7.2: Types of Intangible Assets

7.2.1: Trademarks

Learning Objective

Summarize how a company would value a trademark

Key Points

• As a trademarks are used to identify a specific type of business or service, they are important for businesses that want to protect their branding.
• A trademark’s value for accounting purposes equals what it cost to acquire.
• Trademarks are not amortized, but if one loses its value, it can be impaired.

Key Terms

Trademark

A word, symbol, or phrase used to identify a particular company’s product and differentiate it from other companies’ products.

impairment

A downward revaluation, a write-down.

Trademarks

A trademark is an image, word, phrase, logo or combination of those elements used to identify a specific type of business or service. A trademark allows a customer to instantly identify a product and associate the item with a response regarding its quality and price. If developed properly, a trademark will allow customers to make a positive connection with the product to which it is attached. In short, a trademark is a visual representation of a business’s brand or logo.

To protect the work that it puts into developing its brand, a company will obtain a trademark. The legal protection of a trademark prevents other businesses from using the specific image and text associated with the brand. In some circumstances, a business may obtain a “common law” trademark. This offers the business some legal protection. Generally, American businesses will register their logo with the U.S. Patent and Trademark Office. This offers them more legal protection, but can also be more expensive to obtain.

A trademark is an intangible asset, as it’s a nonphysical item granting a business the legal right to exclusively use a logo or other item. This means it is reported on a business’s balance sheet.

Valuing Trademarks

Trademarks have enormous value to businesses, although that may not translate to a business’s financial report. A business can only value any intangible asset, including a trademark, based on what it cost to acquire. For example, if a business purchased a product line from another company, the trademark associated with that product could have a high value on the acquiring company’s books.

The value of a trademark can also be quite low. All costs associated with creating the logo or promoting its public awareness are not included in the trademark’s value if the business did all these tasks internally. As a result, some trademarks could have no value on a company’s books despite a significant investment by the business.

Annual Review of Trademarks

Some intangible assets are amortized over time. This means that the value decreases every year as an expense for using the item. The amount the value of the asset decreases also decreases the business’s income for that year. Trademarks are not amortized since each is considered to have an indefinite life, meaning a perception exists that a trademark can retain its value forever.

However, a business must reassess the value of its trademarks annually. If a business determines that one of its trademarks is worth less than it was a year ago, the value of the intangible asset must be impaired. When an impairment occurs, the value of the asset must be decreased to its current market value. The difference between the current value of the trademark and its former value must be recorded as a financial loss.

7.2.2: Copyrights

Learning Objective

Describe how to value a copyright

Key Points

• A work of authorship can include poetry, novels, computer software, movies, plays, songs and architectural drawings.
• Most copyrights last for the duration of an author’s life plus 70 years.
• The value of a copyright equals the cost it took to secure the legal copyright on a work the business created, or the price the business paid to purchase the copyright from the original owner.
• Every year, the company must amortize the value of the copyright by an amount equal to the original value of the copyright divided by the projected amount of time that the copyright will be able to generate revenue.

Key Terms

amortization

The cost distribution of an intangible asset, like an intellectual property right, over the projected useful life of the asset.

Copyright

the right by law to be the entity which determines who may publish, copy and distribute a piece of writing, music, picture or other work of authorship

Copyrights

A copyright is a legal protection preventing others from publishing or reproducing works of authorship. A work of authorship can include poetry, novels, plays, computer software and architectural drawings. A person who creates a work of authorship has a copyright the moment the work is created and is fixed in a form that either a person or machine can read. As a result, an author does not have to register their work with the U.S. Copyright Office. Formally registering a work is generally recommend because it provides additional legal protection against those who would copy the work.

A copyright only lasts so long, but how long it lasts depends on several factors. Generally, most copyrights last for the duration of an author’s life plus 70 years. If it is an anonymous work or something done for hire, the copyright lasts for 95 years after it was published or 120 years from the year it was created.

While a copyright is associated with a tangible work, since it is a legal right it is also classified as an intangible asset and can be included on a business’s balance sheet.

Valuing a Copyright

The value a business attaches to a copyright depends on how it was acquired. If the business developed the work in question, the value of the copyright is equal to the cost the business incurred securing the copyright. This would include any legal or application fees it might have incurred to obtain the copyright.

If the business purchased the copyright from another company, the business will record the acquired asset at it acquisition cost.

Amortizing a Copyright

Since a copyright eventually terminates, it is amortized. This means that every year the value of the copyright on the company’s books will decrease. The business will record an amortization expense to reflect the decrease in the asset’s value. Generally, an intangible asset like a copyright is amortized via the straight-line method. This means that the book value of the copyright is divided by the useful life of the copyright to determine the amortization amount. The useful life determines how long the business expects the copyright to provide it revenue, and therefore may not equal the full term of the copyright.

Every year, the amortization amount is subtracted from the value of the copyright and is listed as an expense. This continues until the value of the copyright equals zero.

7.2.3: Patents

Learning Objective

Explain how a company values a patent

Key Points

• There are three types of patents. A utility patent is for processes, machines, and articles of manufacture. A design patent is used for any new, original ornamental design that can be affixed to an item of manufacture. A plant patent is granted to anyone that has invented or created a new plant.
• A U.S. patent lasts for 20 years.
• The value of a patent depends on how it was acquired. If developed internally, the book value of the patent could be quite low since all R&D expenditures are listed as expenses when incurred. If the business purchased the patent, its value equals the acquisition cost.
• The value of the patent must be amortized over its useful life, which can be no longer than 20 years.

Key Terms

book value

The value of an asset as reflected on an entity’s accounting books, net of depreciation, but without accounting for market value appreciation.

patent

A declaration issued by a government agency declaring someone the inventor of a new invention and having the privilege of stopping others from making, using, or selling the claimed invention.

incur

To render somebody liable or subject to.

Patents

A patent is a legal license granting its holder the exclusive right to make, use, or sell a specific invention. There are three types of patents. A utility patent is for processes, machines, and articles of manufacture. The light bulb and the Model T would have been utility patents. A design patent is used for any new, original ornamental design that can be affixed to an item of manufacture, such as a hood ornament for a Model T. A plant patent is granted to anyone that has invented or created a new plant, such as a unique strain of corn.

A U.S. patent currently lasts 20 years. Despite the fact that a patent is connected to a specific type of item, a patent represents a legal right and not a tangible item. A patent is classified as an intangible asset and is listed on a company’s balance sheet.

Valuing a Patent

The value of a patent that a company would record on its books depends on how it acquired the patent. If the business developed the invention internally, all the research and development costs associated with that item would have been listed as an expense as those fees were incurred. Therefore, the initial value of an internally developed patent could be quite low.

If the business purchased the patent from the original holder, the value of the patent equals the acquisition cost.

The value of the patent may be increased if a patent holding company defends its rights to the invention in a lawsuit. If the company uses an outside law firm, all fees the business pays to the firm to defend the patent will be included as part of the patent’s book value.

Amortizing a Patent

Since a patent is only valid for a limited number of years, a business is required to amortize it. The process of amortization requires decreasing the value of the asset annually by an amount equal to the value of the asset divided by the number of years of the patent’s useful life. The useful life of the patent can be no longer than how much time is left on the patent’s term, but should reflect the period that the underlying invention can generate revenue for the business that owns it. Every year the business records a decrease in the patent’s value, it must also record a corresponding amortization expense equal to the decrease.

For example, assume a business acquires a patent that has 15 years left on its term for 1 million dollars. However, the invention the patent secures will only generate revenue for ten years. For the next ten years, the company must decrease the value of the asset by 100,000. To ensure the books are balanced, the business must also record a $100,000 amortization expense for the next ten years.

7.2.4: Goodwill

Learning Objective

Describe how a company values Goodwill

Key Points

• A company may only record goodwill on its balance sheet in connection to a business or business segment it acquired.
• Goodwill = acquisition price – net assets.
• Goodwill is not amortized, but it can be impaired if the present value of the future revenues of the related business segment are less than the net assets (including goodwill) of the business segment.

Key Terms

net assets

The value of a business’s assets minus the value of its liabilities.

impair

To decrease the value of an intangible asset.

goodwill

Represents the difference between the firm’s total net assets and its market value; the amount is recorded at time of acquisition.

Goodwill

The value of a business is not always defined by what assets it owns and what it owes. A successful business will develop customer loyalty and an overall positive reputation in its community, which will cause its market value to be greater than its book value. A company may also generate a higher value if it proves over time that it can generate superior revenues than its competition through managerial expertise, its reputation within its business sector, and other company attributes.

The difference between the value of a company as reflected in its balance sheet and its market value is known as its goodwill. Accounting goodwill is the excess value of a firm’s net assets and is recorded at time of business acquisition or combination. Goodwill is not associated with a physical object that the business owns, so it is an intangible asset and is listed on a company’s balance sheet. In comparison, economic goodwill refers to company attributes that are hard to quantify, such as brand loyalty, brand recognition, company innovation, and executive talent .

Valuing Goodwill

A company can list goodwill on its balance sheet when it acquires another business at a higher cost than what the assets and liabilities on the acquired company’s balance sheet dictate. In short, goodwill equals the acquisition price minus net assets.

Say a business was purchased for 100 million. Its assets were worth 80 million but it had 30 million in liabilities. The acquired business’ assets would be equal to 50 million, and the acquiring business would record 50 million worth of goodwill on its balance sheet.

However a business may not record goodwill that it generates for itself. Using the same example, assume the business was not acquired, but it was worth 100 million and still had 80 million of assets with 30 million in liabilities. The business would not be able to record the 50 million of goodwill on its own balance sheet. Goodwill can only be recorded when an entire business or an entire section of a business is purchased at a price greater than the value of its assets.

Annual Review of Goodwill

It used to be that goodwill was amortized. This meant that the value of goodwill was decreased annually, with the business recording a loss equal to the amount of the decrease in value. As of 2001, goodwill is no longer amortized.

Every year the value of goodwill must be evaluated by the business that owns it. The company must determine the present value of all of the future revenues of the business segment associated with the goodwill. If the present value of those revenues equal or exceed the value of the business segment’s carrying value, or its total assets (including goodwill) minus assets, the business does not have to make any changes.

If the present value of the future revenues is less than the business segment’s carrying value, the business must impair, or decrease the value, of the goodwill account. Goodwill must be decreased so that the segment’s carrying value equals the present value of its revenues. If the the total value of goodwill is not enough to make up the difference, the goodwill balance must be set to zero. A business cannot have a negative goodwill balance.

Any impairment of goodwill is recognized as a loss for year of the decrease and reported on the income statement.

7.2.5: Franchises and Licenses

Learning Objective

Explain how a company values a franchise or license

Key Points

• If a franchisee makes periodic payments to the franchisor, it does not record a franchise asset. If the contract requires that a lump sum be paid up front to secure the franchise rights for several years, the franchisee would record a franchise asset on its balance sheet.
• A business only records a license asset on its balance sheet if the term of the license ends after the date of the balance sheet.
• Amortizing only applies if the business records an asset. The amortization rate is calculated by dividing the initial value of the asset by its useful life. Every accounting period, the business decreases the value of the asset by the amortization rate and records an expense equal to the rate.

Key Terms

license

the legal terms under which a person is allowed to use a product

franchise

The authorization granted by a company to sell or distribute its goods or services in a certain area.

franchisee

A holder of a franchise; a person who is granted a franchise.

franchisor

A company which or person who grants franchises.

A franchise is a contract that grants a business the right to operate using the name and products of an established brand. A franchisor will develop the brand, produce goods and develop marketing campaigns for its products. A franchisee will then purchase the rights to sell the franchisor’s products in a given area and benefit from the franchisor’s marketing efforts. The franchisor makes money by selling rights to franchisees, while the franchisee profits by selling directly to customers. A common industry that uses franchising is fast food.

A license is similar to a franchise, in that it grants someone the right to legally use someone else’s intellectual property or gooda. This license will contain terms that will define how the purchaser can use the product and whether she can share it. A common example of a license a business might purchase is for software.

Valuing Franchises and Licenses

How a franchise is recorded on a balance sheet depends on the conditions of the contract. If a franchisee makes periodic payments to the franchisor over the contract’s term, the franchisee does not record a franchise asset. Instead, the franchisee records a franchise expense when she pays the franchise fee.

If the contract requires that a lump sum be paid up front to secure the franchise rights for several years, the franchisee would record a franchise asset on its balance sheet. Therefore, the value of the franchise asset equals what it cost to acquire.

The same rules apply to a license. If a business must pay licensing fees on a monthly or on an annual basis that coincides with the end of the business’s fiscal year, the business does not record a license asset. The fees that the business paid for those licenses are included as an expense. If the license is for multiple years or accounting periods and is acquired by paying an initial fee, the license is recorded as an asset on the balance sheet and its value equals what it cost to acquire the license.

Amortizing Franchises and Licenses

Amortizing is a term that only applies if there is a franchise or license asset. Amortization is the process of writing off the cost of an asset over its useful life. Useful life is the amount of time that a business can generate revenues from the asset. For a franchise, the useful life is generally the length of the franchise contract. The useful life of a license is how long it grants the holder the exclusive right to use the underlying product.

The amortization rate is calculated by dividing the initial value of the asset by its useful life. Depending on when the balance sheet is issued, the useful life is presented as a number of months, quarters, or years. Every accounting period, the value of the asset is decreased by the amortization rate. The business also records an expense equal to the amortization rate every accounting period.

6.2: Components of Asset Cost

6.2.1: Cost of Land

Learning Objective

Describe how land is reported on the financial statements

Key Points

• Land is defined as the ground the company uses for business operations; it includes ground on which the company locates its headquarters or land used for outside storage space or as a parking lot.
• Unlike a majority of fixed assets, land is not subject to depreciation.
• Land is listed on the balance sheet under the section for non-current assets. Increases in market value are disregarded on the balance sheet.
• At time of sale, the difference between a land’s market value and historical cost is recognized as a gain or loss on the income statement.

Key Terms

balance sheet

A balance sheet is often described as a “snapshot of a company’s financial condition. ” A standard company balance sheet has three parts: assets, liabilities, and ownership equity.

income statement

Displays the revenues recognized for a specific period and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the reporting period.

Land and Historical Cost

Land is defined as the ground occupied by a business’ operations. This can include a company’s headquarters, outside storage space or the company’s parking lot.

Land is recognized at its historical cost, or the cost paid to purchase the land, along with any other related initial costs spent to put the land into use.

Land is a type of fixed asset, but unlike a majority of fixed assets, it is not subject to depreciation.

Land on the Balance Sheet

Land is listed on the balance sheet under the section for long-term or non-current assets. If the land’s market value increases over time, its value on the balance sheet remains at historical cost.

For example, land purchased in 1988 for $90,000, would still appear on the December 31, 2010 balance sheet at $90,000, even though its market value is now $300,000. This is based on the assumption that land is acquired for business use and not as an asset held for sale.

Sale of Land

If at a future date the land is sold due to a business relocation or other reason, the difference between the land’s market value and its historical cost will result in a gain or loss disclosed on the income statement. If the sale of land results in a gain, the additional cash or value received in excess of historical cost will increase net income for the period. If the sale results in a loss and the business receives less than the land’s historical cost, the loss will reduce net income for the period.

6.2.2: Cost of Buildings

Learning Objective

Summarize how a company would calculate the cost of a building

Key Points

• Buildings are listed at historical cost on the balance sheet as a long-term or non-current asset.
• Buildings are subject to depreciation or the periodic reduction of value in the asset that is expensed on the income statement and reduces net income.
• Since buildings are subject to depreciation, their cost is adjusted by accumulated depreciation to arrive at their net carrying value on the balance sheet.
• If at a future date a building is sold, any gain or loss on the sale is based on the difference between the building’s net carrying value and the market sales price.

Key Term

Accumulated Depreciation

Accumulated depreciation is known as a contra account, because it separately shows a negative amount that is directly associated with another account.

Buildings and Historical Cost

A building is an asset used for commercial purposes and includes office buildings, warehouses, or retail establishments (i.e., convenience stores, “big box” stores, shopping malls, etc.). The cost of a building is its original purchase price or historical cost and includes any other related initial costs spent to put it into use. Similar to land, buildings are also a type of fixed asset purchased for continued and long-term use in earning profit for a business. Unlike land, buildings are subject to depreciation or the periodic reduction of value in the asset that is expensed on the income statement and reduces income. They also can incur substantial maintenance costs, which are expensed on the income statement and reduce an accounting period’s income.

Buildings on the Balance Sheet

Buildings are listed at historical cost on the balance sheet as a long-term or non-current asset, since this type of asset is held for business use and is not easily converted into cash. Since buildings are subject to depreciation, their cost is adjusted by accumulated depreciation to arrive at their net carrying value on the balance sheet. For example, on Acme Company’s balance sheet, their office building is reported at a cost of $150,000, with accumulated depreciation of $40,000. The building’s net carrying value or net book value, on the balance sheet is $110,000.

Sale of Buildings

If at a future date a building is sold due to a business relocation or other reason, any gain or loss on the sale is based on the difference between the building’s net book value and the market sales price. If the sale results in a gain, the excess received over the building’s net book value is disclosed on the income statement as an increase to the accounting period’s income. If the sale results in a loss and the business receives less than book value, the loss is also disclosed on the income statement as a decrease to income.

6.2.3: Cost of Equipment

Learning Objective

Describe how a company calculates the cost of a piece of equipment

Key Points

• Fixed assets are long term items such as property plant or equipment.
• Equipment is listed on the balance sheet at its historical cost amount, which is reduced by accumulated depreciation to arrive at a net carrying value or net book value.
• Selling equipment triggers a gain or a loss, depending on the difference between the equipment’s net book value and its sale price.

Key Terms

property, plant, and equipment

an accounting term for certain fixed assets and property which will be used for a long period of time, such as land, machinery, and factories

International Accounting Standard

accounting rules that are a part of IFRS (International Financial Reporting Standards), a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.

book value

the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset.

Equipment and Historical Cost

Fixed assets, also known as non-current or tangible assets, include property, plant, and equipment. Fixed assets, according to International Accounting Standard (IAS) 16, are long range assets whose cost can be measured reliably.

The equipment’s cost is calculated by adding the item’s purchase price, or historical cost, to the other costs related to acquiring the asset. These additional costs can include import duties and deductible trade discounts and rebates.

Historical cost also includes delivery and installation of the asset, as well as the dismantling and removal of the asset when it is no longer in service. Equipment is subject to depreciation. Depreciation is a periodic reduction in an asset’s value. It is disclosed on the income statement and appears as a contra-asset account on the balance sheet.

Equipment and the Balance Sheet

Since accounting standards state that an asset should be carried at the net book value, equipment is listed on the balance sheet at its historical cost amount. The cost is then reduced by accumulated depreciation to arrive at a net carrying value or net book value. A company is free to decide what depreciation method to use on the equipment.

Sale of Equipment

When an equipment is sold, the sale of the asset can trigger a gain or a loss, depending on the difference between the equipment’s net book value and its sale price. As with other assets, gain or losses on sales of equipment are disclosed on the income statement as a reduction or addition to income for the period.

6.2.4: Cost of Improvements

Learning Objective

Describe how a company would account for costs associated with improving an asset

Key Points

• Asset improvements are undertaken to enhance or improve a business asset that is in use.
• Since the cost of the improvement is capitalized, the asset’s periodic depreciation expense will be affected (increased).
• If the asset improvement is financed, the interest cost associated with the improvement should not be capitalized as an addition to the asset’s historical cost.
• Depending on the nature of the improvement, it also is possible that the asset’s useful life and salvage value may change as a result of the enhancements.
• Note the difference between an improvement (capitalized) and a maintenance charge (expensed) from a reporting perspective.

Key Terms

cost principle

assets should always be recorded at their purchase price

capital improvements

Activities directed towards expanding the capacity of an asset or otherwise upgrading it to serve needs different from, or significantly greater than, its current use.

historical cost

The original monetary value of an economic item and based on the stable measuring unit assumption. Improvements may be added to an asset’s cost.

Capitalization of Asset Improvements

Asset or capital improvements are undertaken to enhance or improve a business asset that is in use. The cost of the improvement is capitalized and added to the asset’s historical cost on the balance sheet. Since the cost of the improvement is capitalized, the asset’s periodic depreciation expense will be affected, along with other factors used in calculating depreciation. Capital improvements should not be confused with regular maintenance expenses to maintain an asset’s functionality, which are regarded as period costs that are expensed on the income statement and reduce income for the period.

Financing Improvements

If the capital improvement is financed, the interest cost associated with the improvement should not be capitalized as an addition to the asset’s historical cost. Interest costs are not capitalized for assets that are not under construction. For example, Acme Company decides to add the company’s logo to their delivery trucks and takes out a $5,000 loan. In 201X, the interest expense is $50; the interest expense is a period cost and reported on the income statement for 201X and not added to the asset’s historical cost.

Asset Improvements and Depreciation

When the cost of a capital improvement is capitalized, the asset’s historical cost increases and periodic depreciation expense will increase. Depending on the nature of the improvement, it is also possible that the asset’s useful life and salvage value may change as a result. The change in periodic depreciation expense also can be impacted by the method used to calculate depreciation and may also have federal income tax consequences.

Asset Improvement vs. Maintenance

Asset improvements are capitalized and reported on the balance sheet because they are for expenses that will provide a benefit beyond the current accounting period. For example, costs expended to place the company logo on a delivery truck or to expand the space on a warehouse would be capitalized because the value they provide will extend into future accounting periods. Maintenance costs are expensed and reported on the income statement as a reduction to current revenues because they provide a benefit in the current accounting period and should be matched with the revenues earned during this period. Examples of expensed costs include payment of regular service maintenance on equipment and machinery.

6.2.5: Cost of Interest During Construction

Learning Objective

Explain how a company records interest on a construction loan

Key Points

• The cost of interest incurred and/or paid is included as part of the historical cost of the asset under construction. No separate line item is needed on the balance sheet.
• The asset under construction should be intended for the generation of company earnings and should not be retail inventory or inventory held for sale.
• Do not capitalize interest costs during delays in the construction phase.
• When the asset’s construction is complete and the asset is ready for use, any additional interest expense incurred is no longer capitalized as part of the asset’s cost.

Key Terms

inventory

A detailed list of all of the items on hand.

capitalization

The act of calculating the present value of an asset.

Capitalizing Interest Costs

Interest is defined as a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds. When an asset is constructed, a company typically borrows funds to finance the costs associated with the construction. The amount of cash borrowed will incur interest expense to the borrower; the interest paid by the borrower serves as interest income to the lender. The capitalization of interest costs involves adding the amount of interest expense incurred and/or paid during the asset’s construction phase to the asset’s cost recorded on the balance sheet. The asset’s intended use should be for the generation of company earnings. Interest cost capitalization does not apply to retail inventory constructed or held for sale purposes.

Interest Costs on the Balance Sheet

The cost of interest incurred and/or paid is included as part of the historical cost of the asset under construction. No separate line item is needed on the balance sheet to disclose the interest costs associated with the asset. If any delays occur during the construction phase, the interest costs incurred during the delay are not capitalized. This interest cost is recorded as interest expense and reported as a period cost on the income statement rather than the balance sheet.

Interest Costs After Construction

When the asset’s construction is complete and the asset is ready for use, any additional interest expense incurred is no longer capitalized as part of the asset’s cost. This interest is expensed on the income statement and reduces income for the accounting period.

5.2: Controlling Inventory

5.2.1: Internal Controls

Learning Objective

Explain how a company would use storage, inventory management systems and inventory counts to control inventory

Key Points

• Companies should store inventory in secure spacious warehouses so that inventory is not stolen or damaged. Goods and resources of the same or similar type should be kept in the same general area of the warehouse to minimize confusion and to ensure accurate counts.
• An inventory management system is a series of procedures, often aided by computer software, that tracks assets progression through inventory. A properly used and maintained inventory management system allows management to be able to know how much inventory it has at any given time.
• Detailed physical inventory counts are a way of ensuring that a company’s inventory management system is accurate and as a check to make sure goods are not being lost or stolen. A physical count of a company’s entire inventory is generally taken prior to the issuance of a company’s balance sheet.
• To conduct a cycle count, an auditor will select a small subset of inventory, in a specific location, and count it on a specified day. The auditor will then compare the count to the related information in the inventory management system to ensure the information in the system is correct.

Key Terms

internal auditor

one who conducts an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations

physical inventory count

Physical inventory is a process where a business physically counts its entire inventory. A physical inventory may be mandated by financial accounting rules or the tax regulations to place an accurate value on the inventory, or the business may need to count inventory so component parts or raw materials can be restocked. Businesses may use several different tactics to minimize the disruption caused by physical inventory.

cycle counts

Process by which an auditor selects a small subset of inventory and counts it to ensure that it matches the information in the company’s inventory management system. Meant to test the accuracy of inventory system.

Internal controls over a company’s inventory are meant to ensure that management has an accurate count of what materials and goods it has available for sale and to protect those goods from being spoiled, stolen or otherwise made unavailable for sale. In short, inventory internal controls are meant to ensure that a company always has sufficient resources to produce and sell goods to meet its customers’ needs without having oversupply.

This process is affected by the company’s structure, its employees, and its informational systems. Since a company’s inventory is directly tied to the business’s ability to generate profit, the internal controls must be comprehensive and require significant thought when being designed.

Storage

Companies should store inventory in secure, spacious warehouses so that inventory is not stolen or damaged. Goods and resources of the same or similar type should be kept in the same general area of the warehouse to minimize confusion and to ensure accurate counts.

Inventory Management Systems

An inventory management system is a series of procedures, often aided by computer software, that tracks assets progression through inventory. For example, assume a set amount of raw material is acquired by the company. When the company receives that material, the amount should be noted in the inventory management system. As the material is processed into the goods for resale, the amount of raw material used should be deducted from the “raw material inventory” and the amount of goods that result from the process should be added to the “finished goods inventory. ” As each finished item is sold, the “finished goods inventory” should be decreased by that amount.

The benefit of a properly used and maintained inventory management system is that it allows management to be able to know how much inventory it has at any given time.

Physical Inventory Count

Physical inventory counts are a way of ensuring that a company’s inventory management system is accurate and as a check to make sure goods are not being lost or stolen. A detailed physical count of a company’s entire inventory is generally taken prior to the issuance of a company’s balance sheet, to ensure that the company accurately report its inventory levels.

Cycle Counts

Companies usually conduct cycle counts periodically throughout an accounting period as a means to ensure that the information in its inventory management system is correct. To conduct a cycle count, an auditor will select a small subset of inventory, in a specific location, and count it on a specified day. The auditor will then compare the count to the related information in the inventory management system. If the counts match, no further action is taken. If the numbers differ, the auditor will take additional steps to determine why the counts do not match.

Cycle counts contrast with traditional physical inventory in that a full physical inventory may stop operation at a facility while all items are counted at one time. Cycle counts are less disruptive to daily operations, provide an ongoing measure of inventory accuracy and procedure execution, and can be tailored to focus on items with higher value, higher movement volume, or that are critical to business processes. Cycle counting should only be performed in facilities with a high degree of inventory accuracy.

5.2.2: Perpetual vs. Periodic Counting

Learning Objective

Explain the differences between perpetual inventory and periodic inventory

Key Points

• Perpetual inventory, also called continuous inventory, is when information about amount and availability of the product is updated continuously, usually via computer.
• Periodic inventory is a system of inventory in which updates are made on a periodic basis.
• Theft, breakage, or untracked movement can cause the perpetual inventory to be inaccurate.

Key Terms

periodic inventory system

accounting for goods and materials held for eventual sale that is not continually updated

perpetual

Continuing uninterrupted

breakage

Something that has been broken.

Perpetual Inventory

Perpetual inventory, also called continuous inventory, is when information about amount and availability of a product is updated continuously. Generally, this is accomplished by connecting the inventory system either with the order entry system or for a retail establishment the point of sale system.

A company using the perpetual inventory system would have a book inventory that is exactly (within a small margin of error) the same as the physical (real) inventory.

Periodic Inventory

Periodic inventory is when information about amount and availability of a product is updated only periodically. Physical inventories are conducted at set time intervals; both cost of goods sold and the inventory are adjusted at the time of the physical inventory. Most companies who use periodic inventory perform this at year-end.

Periodic vs. Perpetual

In earlier periods, non-continuous or periodic inventory systems were more prevalent. Many small businesses still only have a periodic system of inventory.

Perpetual inventory systems can still be vulnerable to errors due to overstatements (phantom inventory) or understatements (missing inventory) that occurs as a result of theft, breakage, scanning errors, or untracked inventory movements. These errors lead to systematic errors in replenishment.

While the perpetual inventory method provides a close picture of the true inventory information, it is a good idea for companies using a perpetual inventory system to do a physical inventory periodically.

5.2.3: Conducting a Physical Inventory

Learning Objective

Identify the three phases of a physical inventory

Key Points

• Physical inventory is a process where a business physically counts its entire inventory.
• In the planning and preparation period, a list of stocks which is supposed to be counted are set up. Different teams are then assigned to count the stock.
• Each team counts a specific inventory. The results are recorded on the inventory listing sheet.
• The physicial count is compared to the computer count. The company must note any discrepancies between the actual number and the computer system, recount these inventory items to determine the correct quantity, and adjust the computer inventory quantity if needed.
• Any discrepancies between the actual number and the computer system must be fixed.

Key Terms

perpetual inventory system

Perpetual inventory or continuous inventory updates information on inventory quantity and availability on a continuous basis as a function of doing business. Generally this is accomplished by connecting the inventory system with order entry and in retail the point of sale system.

cycle counting

A cycle count is an inventory auditing procedure, which falls under inventory management, where a small subset of inventory, in a specific location, is counted on a specified day. Cycle counts contrast with traditional physical inventory in that a full physical inventory may stop operation at a facility while all items are counted at one time. Cycle counts are less disruptive to daily operations, provide an ongoing measure of inventory accuracy and procedure execution, and can be tailored to focus on items with higher value, higher movement volume, or that are critical to business processes.

Conducting a Physical Inventory

Physical inventory is a process where a business physically counts its entire inventory. Companies perform a physical inventory for several reasons including to satisfy financial accounting rules or tax regulations, or to compile a list of items for restocking.

Most companies choose to do a physical inventory at year-end.

Businesses may use several different tactics to minimize the disruption caused by physical inventory. For instance, inventory services provide labor and automation to quickly count inventory and minimize shutdown time.

In addition, inventory control system software can speed the physical inventory process . A perpetual inventory system tracks the receipt and use of inventory, and calculates the quantity on hand. Cycle counting, an alternative to physical inventory, may be less disruptive.

The Phases Of Physical Inventory

There are three phases of a physical inventory:

• Planning and preparation
• Execution
• Analysis of results

Planning and Preparation

In the planning and preparation period, a list of stocks that need to be counted is set up. Teams are then assigned and sent to count the stock.

Execution

The teams count the inventory items and record the results on an inventory-listing sheet.

Analysis Of Results

When analyzing the results, a company must compare the inventory counts submitted by each team with the inventory count from the computer system. If any discrepancies occur between the actual number and the computer system, it may be necessary to recount the disputed inventory items to determine the correct quantity. After the final amounts are determined, the company must make an adjusting entry to the computer inventory.

5.2.4: Impact of Measurement Error

Learning Objective

Explain how a measurement error affects a company’s inventory value

Key Points

• In inventory controlling, measurement error is the difference between the actual number of stocks and the value obtained by measurement.
• Inventory systems can be vulnerable to errors due to overstatements (phantom inventory) or understatements (missing inventory). Overstatements and understatements can occur as a result of theft, breakage, scanning errors or untracked inventory movements.
• Based on inaccurate measurement data, the company will make either excessive orders or late orders which then may cause production disruption. In sum, systematic measurement error can lead to errors in replenishment.
• An incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income.

Key Term

phantom inventory

Phantom inventory is a common expression for goods that an inventory accounting system considers to be on-hand at a storage location, but are not actually available. This could be due to the items being moved without recording the change in the inventory accounting system, breakage, theft data entry errors or deliberate fraud. The resulting discrepancy between the online inventory balance and physical availability can delay automated reordering and lead to out-of-stock incidents. If not addressed, phantom inventory can also result in broader accounting issues and restatements.

Measurement Error Impacts

Measurement error is the difference between the true value of a quantity and the value obtained by measurement. The two main types of error are random errors and systematic errors. In inventory controlling, measurement error is the difference between the actual number of stocks and the value obtained by measurement.

Inventory systems can be vulnerable to errors due to overstatements (phantom inventory) when the actual inventory is lower than the measurement or understatements (missing inventory) when the actual stocks are higher than the measurement. Overstatements and understatements can occur as a result of theft, breakage, scanning errors or untracked inventory movements. It is quite easy to overlook goods on hand, count goods twice, or simply make mathematical mistakes.

Based on inaccurate measurement data, the company will make either excessive orders or late orders which then may cause production disruption. In sum, systematic measurement error can lead to errors in replenishment.

Inventory controlling helps revenue and expenses be recognized. As a result, an incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. A general rule is that overstatements of ending inventory cause overstatements of income, while understatements of ending inventory cause understatements of income. Since financial statement users depend upon accurate statements, care must be taken to ensure that the inventory balance at the end of each accounting period is correct. It is also vital that accountants and business owners fully understand the effects of inventory errors and grasp the need to be careful to get these numbers as correct as possible.

4.2: Managing Cash

4.2.1: Cash Controls

Learning Objective

Explain how internal cash controls benefit a company

Key Points

• Internal controls assure achievement of an organization’s objectives in operational effectiveness and efficiency, reliable financial reporting, and compliance with laws, regulations, and policies.
• According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO), internal control has five components: the control environment, risk assessment, information and communication, control activities, and monitoring processes.
• Businesses will generally be required to perform an audit at least once a year on all of its financial reports and internal controls, including those controls associated with cash.
• Three common types of internal controls for cash include bank reconciliations, voucher systems, and electronic funds transfers (EFT).

Key Terms

internal control

a process affected by an organization’s structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives

internal controls

In accounting and auditing, internal control is defined as a process affected by an organization’s structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives [1]. It is a means by which an organization’s resources are directed, monitored, and measured. It plays an important role in preventing and detecting fraud and protecting the organization’s resources, both physical (e.g., machinery and property) and intangible (e.g., reputation or intellectual property such as trademarks).

electronic funds transfer

the transfer of money from one account to another, either within a single financial institution or across multiple institutions, through computer-based systems

Every business should have internal controls regarding its financial activities. If designed well, internal controls can prevent theft and fraud. They also ensure that a business’s financial statements are accurate .

While internal control should be designed for every aspect of a business’s operation, the controls for cash are arguably among the most important. Since cash is the most liquid asset and the easiest for people to convert for their own needs, it is often the easiest thing to steal or misreport. Therefore, the internal controls associated with cash must be more stringent.

Goals for Internal Cash Controls

• Check that the business’s actual cash balances equal what is recorded in its financial records.
• Ensure that there is enough cash available to pay a business’s debts on time.
• Prevent the business from having “idle funds”—more cash than is necessary to function. These funds can instead by invested for higher return.
• Prevent theft or fraud.

Five Elements of Internal Controls

According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO), internal control has five components:

• The Control Environment. Every business is different. A business comprised of five people will demand different controls than a company with 500 people. Prior to establishing any set of internal controls, you should consider the business’s management philosophy, the integrity of the employees, and the legal requirements established by the state and federal government.
• Risk Assessment. Next, you should consider how a business’s cash is at risk. Are large amounts of cash kept where employees have access to it? Who is responsible for receiving and depositing cash? Who is responsible for giving cash to settle debts? These are the types of questions that address what possible risks a business may face when it comes to cash.
• Control activities. Control activities are steps that a business takes to minimize risks. Examples of control activities include having different employees being responsible for different parts of the transaction. An example of a control activity would be having one person selling the product, another person receiving the money from the sale, and a third person checking to make sure that the agreed sales price equals what was deposited.
• Information and communication. Control activities must be designed and then executed by relying on information to be communicated between the people who control different aspects of the transaction. To minimize errors and fraud, the correct information must flow to the right people in a timely manner.
• Monitoring. The entire process must be reviewed by upper level management to ensure that every person is complying with their responsibilities. It is also generally required that the business audits its books and review its internal controls at least annually.

Common Cash Controls

• Bank Reconciliations: A process where the cash accounts on a business’s books are regularly checked against bank statements.
• Voucher System: A system focused on documenting every aspect of every transaction to ensure that all required payments are made and are only made once.
• Electronic Funds Transfer (EFT): By using services that transfer funds automatically, such as through PayPal, a business can minimize the number of people who have access to its funds. These types of transfers also tend to generate documentation showing when the transaction was made and with whom.

4.2.2: Using a Bank for Control

Learning Objective

Describe why a bank is one of the best internal controls a business can use

Key Points

• Internal controls are meant to ensure that a business’s assets are protected, that its financial data is accurate, and to ensure efficiency.
• Most banks keep “signature cards” on hand for business accounts so its tellers are aware of who can sign checks to withdraw funds. All other individuals are prevented from withdrawing cash from the business’s account.
• The bank generally sends the business a monthly statement summarizing the activity related to cash. The statement will generally also include the documentation related to each transaction.

Key Term

control

A security mechanism, policy, or procedure that can counter system attack, reduce risks, and resolve vulnerabilities, synonymous with safeguard and counter-measure.

Money Control through a Bank

Using a bank is one of the best internal controls on a business’s cash. Internal controls are meant to ensure that a business’s assets are protected, that its financial data is accurate, and to ensure efficiency . For cash, this generally requires that the people with the ability to obtain a business’s cash are limited to a few select individuals and that each transaction is recorded in detail. The documents regarding each transaction should list when each deposit or withdrawal took place, who initiated the transaction, and how much cash was involved.

As an independent third party, a bank is less susceptible to schemes by a business’s employees to steal funds. Since a bank holds a business’s funds, it provides a physical barrier preventing employees from accessing the cash. Most banks keep “signature cards” on hand for business accounts so its tellers are aware who can sign checks to withdraw funds. All other individuals are prevented from withdrawing cash from the business’s account.

Banks generally require that every deposit is accompanied by a signed and dated deposit slip. Every withdrawal must be paired with a signed and dated check. These documents are kept by the bank to resolve any disputes that may arise regarding a transaction.

The bank generally also sends the business a monthly statement that summarizes the activity associated with the account. This statement will list all deposits and withdrawals. It will also include a copy of each transaction’s documentation. Generally, the person in charge of the business’s books will receive this documentation and compare it to the business’s own records. If there are any differences between the business records and the bank’s, the company can use the documentation enclosed with the statement to determine where the discrepancy is and contact the peopled involved with the questionable transactions.

4.2.3: Reconciling Cash Accounts and Bank Statements

Learning Objective

Describe how a company uses a bank reconciliation as an internal control

Key Points

• Bank reconciliations are necessary because legitimate transactions that a business has recorded in its books might not be listed on its bank statements and vice versa.
• A bank reconciliation consists of a book balance column and a bank balance column. One column is adjusted by adding all of the legitimate transactions that either the bank statement or books do not show. The reconciliation is complete when the two columns equal each other.
• When a legitimate transaction that was not recorded in the books is discovered, it must be added by recording a journal entry.

Key Terms

bank statement

a communication from a bank to a person holding an account in that bank, usually issued monthly, detailing the value of the holdings in that account and the effects of all transactions occurring with respect to that account

journal entry

A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.

Bank Reconciliation

A process that explains the difference between the bank balance shown in an organization’s bank statement, as supplied by the bank, and the corresponding amount shown in the organization’s own accounting records at a particular point in time.

A bank statement only reflects a specific period of time, such as one month . However, it takes the banks time to prepare the statement and send it out. Therefore, while a bank may prepare a statement for the month of October, a business might not receive it until a week later.

As a result, a bank statement will generally not reflect the amounts that a company has on its own books. This can be due to a few reasons. The company could have issued several checks prior to the end of the period, but the check holders had not cashed the check. The business could have also received some cash amounts prior to the end of the period covered by the statement, but was unable to deposit those amounts until after the period ended. The differences could also be due to mistakes, either by the bank or in the company’s books. The differences could also be due to something more troublesome, such as theft.

A bank reconciliation is a process that explains the difference between the bank statement on the amount shown in the organization’s own financial records. This process is important because it ensures that any differences are due to the timing of payments and not because of a mistake or theft.

Reconciliation Process

A bank reconciliation consists of two columns; one for the book balance, the other for the bank balance. The person reconciling the accounts then adjusts one column by adding deposits that had not yet been recorded and subtracting checks and other outlays that had not yet been cashed when the statement had been prepared. The reconciliation is not complete until the adjusted column equals the unadjusted column.

There may be some cases where the process reveals a legitimate transaction that was not recorded in the books. When that occurs, the person responsible for the business’s books must record the transaction using a journal entry.

4.2.4: Basics of Cash Management

Learning Objective

Explain how a voucher system helps a company manage their cash

Key Points

• A voucher system is used for monitoring cash payments.
• A voucher system consists of vouchers, an unpaid voucher file, a paid voucher file, a voucher register, and a check register.
• Before marking a voucher as paid, the person in charge of the system should check the transaction’s corresponding documentation, which generally includes a purchase order, invoice, and receiving report.
• Deposits are generally monitored through bank reconciliations.

Key Terms

voucher

A receipt.

purchase invoice

the buyer’s name for a commercial document issued by a seller to a buyer, indicating the products, quantities, and agreed prices for products or services the seller has provided the buyer

Managing cash is about monitoring how it comes in and goes out . To meet this goal, a business must come up with a system that not only documents all of these transactions, but organizes those documents in such a way so that any issues are immediately noticed by management.

Voucher System

A voucher system is used primarily for monitoring and documenting payments made by a company to a third party. A voucher is composed of five parts.

• Individual vouchers: A voucher is a document that proves a payment was authorized and eventually made. Each voucher should be assigned a number to identify it. A voucher should be prepared for every transaction.
• Voucher register: Is a book or spreadsheet that lists every voucher.
• Unpaid voucher file: Where all vouchers that have been authorized, but not yet been paid are kept.
• Paid voucher file: Where all paid vouchers are kept. The paid vouchers should be filed in numerical order.
• Check register: A book or spreadsheet that records when all vouchers were paid and how it was paid. If the voucher was paid using a check, the check register will pair the voucher identification numbers with the check identification numbers.

When an obligation is about to be settled, the person in charge of the vouchers should review the other documents associated with the transaction prior to transferring the related voucher from the unpaid to paid file. The related documents generally include purchase orders, receiving reports, and invoices. These documents demonstrate that the payment was authorized, all goods and services that the business was supposed to get were received, and that the amount paid equaled the amount due.

Bank Reconciliations

Bank reconciliations, or the process of checking to make sure that a business’s financial records on cash equals how much is in the business’s bank accounts, are especially useful as a control over deposits. This type of control will be discussed in a later section.

3.2: The Balance Sheet

3.2.1: Defining the Balance Sheet

Learning Objective

State the purpose of the balance sheet and recognize what accounts appear on the balance sheet

Key Points

• The balance sheet summarizes a business’s assets, liabilities, and shareholders’ equity.
• A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time.
• The balance sheet is sometimes called the statement of financial position.
• The balance sheet shows the accounting equation in balance. A company’s assets must equal their liabilities plus shareholders’ equity.

Key Terms

balance sheet

A balance sheet is often described as a “snapshot of a company’s financial condition. ” A standard company balance sheet has three parts: assets, liabilities, and ownership equity.

asset

Items of ownership convertible into cash; total resources of a person or business, as cash, notes and accounts receivable; securities and accounts receivable, securities, inventories, goodwill, fixtures, machinery, or real estate (as opposed to liabilities).

liability

An obligation, debt, or responsibility owed to someone.

Balance Sheet

The balance sheet, sometimes called the statement of financial position, lists the company’s assets, liabilities,and stockholders’ equity (including dollar amounts) as of a specific moment in time. That specific moment is the close of business on the date of the balance sheet. A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time. The other two statements are for a period of time. As you study about the assets, liabilities, and stockholders’ equity contained in a balance sheet, you will understand why this financial statement provides information about the solvency of the business.

The balance sheet is a formal document that follows a standard accounting format showing the same categories of assets and liabilities regardless of the size or nature of the business. Accounting is considered the language of business because its concepts are time-tested and standardized. Even if you do not utilize the services of a certified public accountant, you or your bookkeeper can adopt certain generally accepted accounting principles (GAAP) to develop financial statements. The strength of GAAP is the reliability of company data from one accounting period to another and the ability to compare the financial statements of different companies.

Balance Sheet Formats

Standard accounting conventions present the balance sheet in one of two formats: the account form (horizontal presentation) and the report form (vertical presentation). Most companies favor the vertical report form, which doesn’t conform to the typical explanation in investment literature of the balance sheet as having “two sides” that balance out.

Whether the format is up-down or side-by-side, all balance sheets conform to a presentation that positions the various account entries into five sections:

Assets = Liabilities + Equity

1. Current assets (short-term): items that are convertible into cash within one year

2. Non-current assets (long-term): items of a more permanent nature

3. Current liabilities (short-term): obligations due within one year

4. Non-current liabilities (long-term): obligations due beyond one year

5. Shareholders’ equity (permanent): shareholders’ investment and retained earnings

Account Presentation

In the asset sections mentioned above, the accounts are listed in the descending order of their liquidity (how quickly and easily they can be converted to cash). Similarly, liabilities are listed in the order of their priority for payment. In financial reporting, the terms “current” and “non-current” are synonymous with the terms “short-term” and “long-term,” respectively, so they are used interchangeably.

Each of the three segments on the balance sheet will have many accounts within it that document the value of each. Accounts such as cash, inventory, and property are on the asset side of the balance sheet, while on the liability side there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry.

3.2.2: Components of the Balance Sheet

Learning Objective

Differentiate between the three balance sheet accounts of asset, liability and shareholder’s equity

Key Points

• Assets have value because a business can use or exchange them to produce the services or products of the business.
• Liabilities are the debts owed by a business, often incurred to fund its operation.
• A company’s equity represents retained earnings and funds contributed by its shareholders.

Key Terms

Assets

A resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide future benefit.

liabilities

Probable future sacrifices of economic benefits arising from present obligations to transfer assets or providing services as a result of past transactions or events.

equity

Ownership interest in a company, as determined by subtracting liabilities from assets.

Components of the Balance Sheet

The balance sheet contains statements of assets, liabilities, and shareholders’ equity.

Assets represent things of value that a company owns and has in its possession, or something that will be received and can be measured objectively. They are also called the resources of the business, some examples of assets include receivables, equipment, property and inventory. Assets have value because a business can use or exchange them to produce the services or products of the business.

Liabilities are the debts owed by a business to others–creditors, suppliers, tax authorities, employees, etc. They are obligations that must be paid under certain conditions and time frames. A business incurs many of its liabilities by purchasing items on credit to fund the business operations.

A company’s equity represents retained earnings and funds contributed by its owners or shareholders (capital), who accept the uncertainty that comes with ownership risk in exchange for what they hope will be a good return on their investment.

Fundamental Relationship

The relationship of these items is expressed in the fundamental balance sheet equation:

Assets = Liabilities + Equity

The meaning of this equation is important. Generally, sales growth, whether rapid or slow, dictates a larger asset base – higher levels of inventory, receivables, and fixed assets (plant, property, and equipment). As a company’s assets grow, its liabilities and/or equity also tends to grow in order for its financial position to stay in balance. How assets are supported, or financed, by a corresponding growth in payables, debt liabilities, and equity reveals a lot about a company’s financial health.

3.2.3: Uses of the Balance Sheet

Learning Objective

Give examples of how the balance sheet is used by internal and external users

Key Points

• The Balance Sheet is used for financial reporting and analysis as part of the suite of financial statements.
• Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information.
• Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general purpose financial statements that companies publish.

Key Term

liquidity

A company’s ability to meet its payment obligations, in terms of possessing sufficient liquid assets.

Uses Of the Balance Sheet

The Balance Sheet is used for financial reporting and analysis as part of the suite of financial statements .

Management’s analysis of financial statements primarily relates to parts of the company. Using this approach, management can plan, evaluate, and control operations within the company. Management obtains any information it wants about the company’s operations by requesting special-purpose reports. It uses this information to make difficult decisions, such as which employees to lay off and when to expand operations.

Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general purpose financial statements that companies publish. These statements include the balance sheet, an income statement, a statement of stockholders’ equity, a statement of cash flows, and the explanatory notes that accompany the financial statements.

Users of financial statements need to pay particular attention to the explanatory notes, or the financial review, provided by management in annual reports. This integral part of the annual report provides insight into the scope of the business, the results of operations, liquidity and capital resources, new accounting standards, and geographic area data.

Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company’s past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users of financial statements.

Balance Sheet Substantiation

The balance sheet is an especially useful tool when it comes to the substantiation of various accounts. Balance sheet substantiation is the accounting process conducted by businesses on a regular basis to confirm that the balances held in the primary accounting system of record are reconciled (in balance with) with the balance and transaction records held in the same or supporting sub-systems. It includes multiple processes including reconciliation (at a transactional or at a balance level) of the account, a process of review of the reconciliation and any pertinent supporting documentation, and a formal certification (sign-off) of the account in a predetermined form driven by corporate policy

Balance sheet substantiation is an important process that is typically carried out on a monthly, quarterly and year-end basis. The results help to drive the regulatory balance sheet reporting obligations of the organization. Historically, substantiation has been a wholly manual process, driven by spreadsheets, email and manual monitoring and reporting. In recent years software solutions have been developed to bring a level of process automation, standardization and enhanced control to the substantiation or account certification process. These solutions are suitable for organizations with a high volume of accounts and/or personnel involved in the substantiation process and can be used to drive efficiencies, improve transparency and help to reduce risk.

3.2.4: Preparation of the Balance Sheet

Learning Objective

Identify the elements of a properly formatted balance sheet

Key Points

• Balance sheets are usually prepared at the close of an accounting period, such as month-end, quarter-end, or year-end.
• Current assets most commonly used by small businesses are cash, accounts receivable, inventory and prepaid expenses.
• There are two types of liabilities: current liabilities and long-term liabilities. Liabilities are arranged on the balance sheet in order of how soon they must be repaid.

Key Terms

Fixed assets

Assets that produce revenues. They are distinguished from current assets by their longevity. They are not for resale.

depreciation

Depreciation subtracts a specified amount from the original purchase price to account for the wear and tear on the asset.

inventory

Inventory includes goods ready for sale, as well as raw material and partially completed products that will be for sale when they are completed.

How to Prepare a Balance Sheet

All balance sheets follow the same format: when two columns are used, assets are on the left, liabilities are on the right, and net worth is beneath liabilities. When one column is used, assets are listed first, followed by liabilities and net worth. Balance sheets are usually prepared at the close of an accounting period.

Current Assets

To start, focus on the current assets most commonly used by small businesses: cash, accounts receivable, inventory and prepaid expenses. Cash includes cash on hand, in the bank, and in petty cash. Accounts receivable is what you are owed by customers. To make this number more realistic, an amount should be deducted from accounts receivable as an allowance for bad debts.

Inventory may be the largest current asset. On a balance sheet, the value of inventory is the cost required to replace it if the inventory were destroyed, lost, or damaged. Inventory includes goods ready for sale, as well as raw material and partially completed products that will be for sale when they are completed.

Prepaid expenses are listed as a current asset because they represent an item or service that has been paid for but has not been used or consumed. An example of a prepaid expense is the last month of rent on a lease that may have been prepaid as a security deposit. The prepaid expense will be carried as an asset until it is used. Prepaid insurance premiums are another example of prepaid expenses. Sometimes, prepaid expenses are also referred to as unexpired expenses. On a balance sheet, current assets are totaled and this total is shown as the line item called “total current assets. “

Fixed Assets

Fixed assets are the assets that produce revenues. They are distinguished from current assets by their longevity. They are not for resale. Many small businesses may not own a large amount of fixed assets, because most small businesses are started with a minimum of capital. Of course, fixed assets will vary considerably and depend on the business type (such as service or manufacturing), size, and market.

Fixed assets include furniture and fixtures, motor vehicles, buildings, land, building improvements (or leasehold improvements), production machinery, equipment and any other items with an expected business life that can be measured in years. All fixed assets (except land) are shown on the balance sheet at original (or historic) cost, minus any depreciation. Subtracting depreciation is a conservative accounting practice to reduce the possibility of over valuation. Depreciation subtracts a specified amount from the original purchase price for the wear and tear on the asset.

It is important to remember that original cost may be more than the asset’s invoice price. It can include shipping, installation, and any associated expenses necessary for readying the asset for service. Assets are arranged in order of how quickly they can be turned into cash. Like the other fixed assets on the balance sheet, machineryand equipment will be valued at the original cost minus depreciation. “Other assets” is a category of fixed assets. Other assets are generally intangible assets such as patents, royalty arrangements, and copyrights.

Liabilities

Liabilities are claims of creditors against the assets of the business. These are debts owed by the business.There are two types of liabilities: current liabilities and long-term liabilities. Liabilities are arranged on the balance sheet in order of how soon they must be repaid. For example, accounts payable will appear first as they are generally paid within 30 days. Notes payable are generally due within 90 days and are the second liability to appear on the balance sheet.

Current liabilities include the following:

• Accounts payable
• Notes payable to banks (or others)
• Accrued expenses (such as wages and salaries)
• Taxes payable
• The current amount due within a one year portion of long-term debt
• Any other obligations to creditors due within one year of the date of the balance sheet

The current liabilities of most small businesses include accounts payable, notes payable to banks, and accrued payroll taxes. Accounts payable is the amount you may owe any suppliers or other creditors for services or goods that you have received but not yet paid for. Notes payable refers to any money due on a loan during the next 12 months. Accrued payroll taxes would be any compensation to employees who have worked, but have not been paid at the time the balance sheet is created.

Liabilities are arranged on the balance sheet in order of how soon they must be repaid.

Long-term liabilities are any debts that must be repaid by your business more than one year from the date of the balance sheet. This may include start up financing from relatives, banks, finance companies, or others.

3.2.5: Temporal Classification

Learning Objective

Identify when it would be necessary to use the temporal method on the balance sheet

Key Points

• Inventory, property, equipment, patents, and contributed capital accounts are re-measured at historical rates resulting in differences in total assets and liabilities plus equity which must be reconciled resulting in a re-measurement gain or loss.
• If a company’s functional currency is the U.S. dollar, then any balances denominated in the local or foreign currency, must be re-measured.
• The re-measurement gain or loss appears on the income statement.

Key Terms

Temporal Method

Cash, receivables, and liabilities are re-measured into U.S. dollars using the current exchange rate.

translation

Uses exchange rates based on the time assets. Liabilities acquired or incurred are required.

A Classified Balance Sheet

“Classified” means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. Most accounting balance sheets classify a company’s assets and liabilities into distinct groups such as current assets property, plant, equipment, current liabilities, etc. These classifications make the balance sheet more useful

The Temporal Method

Cash, receivables, and liabilities are re-measured into U.S. dollars using the current exchange rate. Inventory, property, equipment, patents, and contributed capital accounts are re-measured at historical rates resulting in differences in total assets and liabilities plus equity which must be reconciled resulting in a re-measurement gain or loss.

If a company’s functional currency is the U.S. dollars, then any balances denominated in the local or foreign currency, must be re-measured. Re-measurement requires the application of the temporal method. The re-measurement gain or loss appears on the income statement .

Translation

A method of foreign currency translation that uses exchange rates based on the time assetsand liabilities are acquired or incurred, is required. The exchange rate used also depends on the method of valuation that is used. Assets and liabilities valued at current costs use the current exchange rate and those that use historical exchange rates are valued at historical costs.

By using the temporal method, any income-generating assets like inventory, property, plant, and equipment are regularly updated to reflect their market values. The gains and losses that result from translation are placed directly into the current consolidated income. This causes the consolidated earnings to be volatile.

3.2.6: Assets

Learning Objective

Sketch the asset section of a balance sheet

Key Points

• The main categories of assets are usually listed first, and normally, in order of liquidity. On a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets.
• Current assets are those assets which can either be converted to cash or used to pay current liabilities within 12 months. Current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities paid within a year.
• A non-current asset cannot easily be converted into cash. Non-current assets include property, plant and equipment (PPE), investment property, intangible assets, long-term financial assets, investments accounted for using the equity method, and biological assets.

Key Term

liquidity

Availability of cash over short term: ability to service short-term debt.

The Balance Sheet

A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, and normally, in order of liquidity. On the left side of a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets.

Current Assets

A current asset on the balance sheet is an asset which can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities which will be paid within a year.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company’s balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or treasury bills, marketable securities and commercial papers. Cash equivalents are distinguished from other investments through their short-term existence; they mature within 3 months whereas short-term investments are 12 months or less, and long-term investments are any investments that mature in excess of 12 months.

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe, called credit terms or payment terms.

Most manufacturing organizations usually divide their inventory into:

• raw materials – materials and components scheduled for use in making a product,
• work in process (WIP) – materials and components that have began their transformation to finished goods,
• finished goods – goods ready for sale to customers, and
• goods for resale – returned goods that are salable.

A deferred expense or prepayment, prepaid expense (plural often prepaids), is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period. For example, if a service contract is paid quarterly in advance, at the end of the first month of the period two months remain as a deferred expense. In the deferred expense, the early payment is accompanied by a related, recognized expense in the subsequent accounting period, and the same amount is deducted from the prepayment.

Non-current Assets

A non-current asset is a term used in accounting for assets and property which cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as liquid assets. Non-current assets include property, plant and equipment (PPE), investment property (such as real estate held for investment purposes), intangible assets, long-term financial assets, investments accounted for by using the equity method, and biological assets, which are living plants or animals.

Property, plant, and equipment normally include items such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and machinery. These often receive favorable tax treatment (depreciation allowance) over short-term assets.

Intangible assets are defined as identifiable, non-monetary assets that cannot be seen, touched or physically measured. They are created through time and effort, and are identifiable as a separate asset. There are two primary forms of intangibles – legal intangibles (such as trade secrets (e. g., customer lists), copyrights, patents, and trademarks) and competitive intangibles (such as knowledge activities (know-how, knowledge), collaboration activities, leverage activities, and structural activities). The intangible asset “goodwill” reflects the difference between the firm’s net assets and its market value; the amount is first recorded at time of acquisition. The additional value of the firm in excess of its net assets usually reflects the company’s reputation, talent pool, and other attributes that separate it from the competition. Goodwill must be tested for impairment on an annual basis and adjusted if the firm’s market value has changed.

Investments accounted for by using the equity method are 20-50% stake investments in other companies. The investor keeps such equities as an asset on the balance sheet. The investor’s proportional share of the associate company’s net income increases the investment (and a net loss decreases the investment), and proportional payment of dividends decreases it. In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item.

3.2.7: Liabilities and Equity

Learning Objective

Apply the accounting equation to create a balance sheet

Key Points

• In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.
• Equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid.
• The types of accounts and their description that comprise the owner’s equity depend on the nature of the entity and may include: Common stock, preferred stock, capital surplus, retained earnings, treasury stock, stock options and reserve.

Key Term

Preferred Stock

Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock. It also has priority to common stock in liquidation.

In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. A liability is defined by the following characteristics:

• Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time;
• A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand;
• A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement; and,
• A transaction or event obligating the entity that has already occurred.

The accounting equation relates assets, liabilities, and owner’s equity: “” The accounting equation is the mathematical structure of the balance sheet.

In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists. In an accounting context, shareholders’ equity (or stockholders’ equity, shareholders’ funds, shareholders’ capital, or similar terms) represents the remaining interest in assets of a company, spread among individual shareholders of common or preferred stock.

At the start of a business, owners put some funding into the business to finance operations. This creates a liability on the business in the shape of capital, as the business is a separate entity from its owners. Businesses can be considered, for accounting purposes, sums of liabilities and assets: this is the accounting equation. After liabilities have been accounted for, the positive remainder is deemed the owner’s interest in the business.

In financial accounting, owner’s equity consists of the net assets of an entity. Net assets is the difference between the total assets of the entity and all its liabilities. Equity appears on the balance sheet, one of the four primary financial statements.

The assets of an entity includes both tangible and intangible items, such as brand names and reputation or goodwill. The types of accounts and their description that comprise the owner’s equity depend on the nature of the entity and may include: Common stock, preferred stock, capital surplus, retained earnings, treasury stock, stock options and reserve.

The total changes to equity is calculated as follows:

Equity (end of year balance) = Equity (beginning of year balance) +/- changes to common or preferred stock and capital surplus +/- net income/loss (net profit/loss earned during the period) − dividends. Dividends are typically cash distributions of earnings to stockholders on hand and they are recorded as a reduction to the retained earnings account reported in the equity section.

3.2.8: Liquidity

Learning Objective

Calculate a company’s liquidity using a variety of methods.

Key Points

• Liquidity refers to a business’s ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. For assets, liquidity is an asset’s ability to be sold without causing a significant movement in the price and with minimum loss of value.
• A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, typically in order of liquidity.
• For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity, namely the current ratio, the quick ratio, the operating cash flow ratio, and the liquidity ratio (acid test).

Key Terms

liquidity ratio

measurement of the availability of cash to pay debt

cash equivalents

A deferred expense or prepayment, prepaid expense, plural often prepaids, is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period.

In accounting, liquidity (or accounting liquidity) is a measure of the ability of a debtor to pay his debts when they fall due. A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, and typically in order of liquidity. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. Next are cash equivalents, short-term investments, inventories, and prepaid expenses.

Liquidity also refers both to a business’s ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. For assets themselves, liquidity is an asset’s ability to be sold without causing a significant movement in the price and with minimum loss of value.

For a corporation with a published balance sheet, there are various ratios used to calculate a measure of liquidity. These include the following:

• The current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over 100% is normal in a non-banking corporation. However, some current assets are more difficult to sell at full value in a hurry.
• The quick ratio, which is calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities–this gives a measure of the ability to meet current liabilities from assets that can be readily sold.
• The operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income, rather than through asset sales.
• The liquidity ratio (acid test) is a ratio used to determine the liquidity of a business entity. Liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means fully covered. The formula is the following: LR = liquid assets / short-term liabilities.

3.2.9: Working Capital

Learning Objective

Discuss why working capital is an important metric for businesses.

Key Points

• Net working capital is calculated as current assets minus current liabilities.
• Current assets and current liabilities include three accounts which are of special importance: accounts receivable, accounts payable and inventories.
• The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Key Terms

deficit

the amount by which spending exceeds revenue

operating liquidity

The ability of a company or individual to quickly convert assets to cash for the purpose of paying operating expenses.

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including a governmental entity. Along with fixed assets, such as plant and equipment, working capital is considered a part of operating capital.

Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as discounted cash flows (DCFs). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities – for example has paid off some short-term creditors.

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact: accounts receivable (current asset), inventories (current assets), and accounts payable (current liability). The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Inventory management is to identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials – and minimizes reordering costs – and hence, increases cash flow.

Debtors’ management involves identifying the appropriate credit policies, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence, return on capital.

Short-term financing requires identifying the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft).

Cash management involves identifying the cash balance which allows for the business to meet day-to-day expenses, but reduces cash holding costs.

3.2.10: Debt to Equity

Learning Objective

Identify the different methods of calculating the debt to equity ratio.

Key Points

• The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage.
• Preferred stocks can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision.
• The formula of debt/ equity ratio: D/E = Debt (liabilities) / equity = Debt / (Assets – Debt) = (Assets – Equity) / Equity.

Key Term

leverage

The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).

Debt to Equity

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two components are often taken from the firm’s balance sheet or statement of financial position. However, the ratio may also be calculated using market values for both if the company’s debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially. “”

Preferred stocks can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision, but will also take into account the specific features of the preferred shares. When used to calculate a company’s financial leverage, the debt usually includes only the long term debt (LTD). Quoted ratios can even exclude the current portion of the LTD.

Financial analysts and stock market quotes will generally not include other types of liabilities, such as accounts payable, although some will make adjustments to include or exclude certain items from the formal financial statements. Adjustments are sometimes also made, for example, to exclude intangible assets, and this will affect the formal equity; debt to equity (dequity) will therefore also be affected.

The formula of debt/equity ratio: D/E = Debt (liabilities) / equity. Sometimes only interest-bearing long-term debt is used instead of total liabilities in the calculation.

A similar ratio is the ratio of debt-to-capital (D/C), where capital is the sum of debt and equity:D/C = total liabilities / total capital = debt / (debt + equity)

The relationship between D/E and D/C is: D/C = D/(D+E) = D/E / (1 + D/E)

The debt-to-total assets (D/A) is defined asD/A = total liabilities / total assets = debt / (debt + equity + non-financial liabilities)

On a balance sheet, the formal definition is that debt (liabilities) plus equity equals assets, or any equivalent reformulation. Both the formulas below are therefore identical: A = D + EE = A – D or D = A – E

Debt to equity can also be reformulated in terms of assets or debt: D/E = D /(A – D) = (A – E) / E

3.2.11: Market Value vs. Book Value

Learning Objective

Distinguish between market value and book value.

Key Points

• Market value is the price at which an asset would trade in a competitive auction setting.
• Book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset.
• In many cases, the carrying value of an asset and its market value will differ greatly. However, they are interrelated.

Key Term

amortization

The distribution of the cost of an intangible asset, such as an intellectual property right, over the projected useful life of the asset.

Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value, or fair market value. International Valuation Standards defines market value as “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion. “

In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization, or impairment costs made against the asset. An asset’s initial book value is its its acquisition cost or the sum of allowable costs expended to put it into use. Assets such as buildings, land, and equipment are valued based on their acquisition cost, which includes the actual cash price of the asset plus certain costs tied to the purchase of the asset, such as broker fees. The book value is different from market value, as it can be higher or lower depending on the asset in question and the accounting practices that affect book value, such as depreciation, amortization and impairment. In many cases, the carrying value of an asset and its market value will differ greatly. If the asset is valued on the balance at market value, then its book value is equal to the market value.

Ways of measuring the value of assets on the balance sheet include: historical cost, market value or lower of cost or market. Historical cost is typically the purchase price of the asset or the sum of certain costs expended to put the asset into use. Market value is the asset’s worth if it were to be exchanged in the open market in an arm’s length transaction; it can also be derived based on the asset’s present value of the expected cash flows it will generate. Certain assets are disclosed at lower of cost or market in order to conform to accounting’s conservatism principle, which stresses that assets should never be overstated.

3.2.12: Limitations of the Balance Sheet

Learning Objective

Critique the balance sheet

Key Points

• Balance sheets do not show true value of assets. Historical cost is criticized for its inaccuracy since it may not reflect current market valuation.
• Some of the current assets are valued on an estimated basis, so the balance sheet is not in a position to reflect the true financial position of the business.
• The balance sheet can not reflect those assets which cannot be expressed in monetary terms, such as skill, intelligence, honesty, and loyalty of workers.

Key Terms

carrying value

In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset.

Fixed assets

Fixed assets, also known as non-current assets or property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. This can be compared with current assets, such as cash or bank accounts, which are described as liquid assets. In most cases, only tangible assets are referred to as fixed.

Limitations of the Balance Sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, business partnership, corporation, or other business organization, such as an LLC or an LLP. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a “snapshot of a company’s financial condition. ” Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business’ calendar year. There are three primary limitations to balance sheets, including the fact that they are recorded at historical cost, the use of estimates, and the omission of valuable things, such as intelligence.

Fixed assets are shown in the balance sheet at historical cost less depreciation up to date. Depreciation affects the carrying value of an asset on the balance sheet. The historical cost will equal the carrying value only if there has been no change recorded in the value of the asset since acquisition. Therefore, the balance sheet does not show true value of assets. Historical cost is criticized for its inaccuracy since it may not reflect current market valuation.

Some of the current assets are valued on estimated basis, so the balance sheet is not in a position to reflect the true financial position of the business. Intangible assets like goodwill are shown in the balance sheet at imaginary figures, which may bear no relationship to the market value. The International Accounting Standards Board (IASB) offers some guidance (IAS 38) as to how intangible assets should be accounted for in financial statements. In general, legal intangibles that are developed internally are not recognized, and legal intangibles that are purchased from third parties are recognized. Therefore, there is a disconnect–goodwill from acquisitions can be booked, since it is derived from a market or purchase valuation. However, similar internal spending cannot be booked, although it will be recognized by investors who compare a company’s market value with its book value.

Finally, the balance sheet can not reflect those assets which cannot be expressed in monetary terms, such as skill, intelligence, honesty, and loyalty of workers.

2.2: The Accounting Cycle

2.2.1: What Is the Accounting Cycle?

Learning Objective

Identify and complete the 8 steps in the Accounting Cycle

Key Points

• The accounting cycle has 8 Steps.
• Each transaction must be analyzed to determine whether it qualifies as a business transaction.
• The accounting cycle runs within the accounting period.
• The goal of the accounting cycle is to produce financial statements for the company.

Key Terms

source

The person, place or thing from which something (information, goods, etc. ) comes or is acquired.

bookkeeping

The skill or practice of keeping books or systematic records of financial transactions, e.g., income and expenses.

summarize

To give a recapitulation of the salient facts; to recapitulate or review

Example

• As we walk through the steps of the accounting cycle, consider the following example. After a number of years as a successful CPA at a national firm, you decide to quit the rat race and pursue your true love — yoga. You decide that Atlanta’s Virginia-Highland neighborhood would be the perfect place to open an Ashtanga Yoga studio. Even better, your friend Solomon, a certified instructor, has just moved to town and is willing to teach at the studio. You hurriedly prepare to open the studio, Highland Yoga, by July 1.Pre-opening (before July 1)Prior to opening the business, you make the following transactions:1. You contribute $4,000 in cash to start the business.2. You purchase $500 worth of mats and other equipment for use during classes.3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.JulyThe following transactions take place during July.1. You receive cash totaling $800 for classes.2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.3. You pay rent for July of $1,000 on July 1.4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.AugustThe following transactions take place during August.1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September.2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.3. Utilities total $150, payable September 15.4. You pay rent of $1,000 on August 1.5. You sell inventory costing $150 for a revenue of $225.6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn’t say when.7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15.8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.

The Accounting Cycle

The accounting cycle is a series of steps performed during the accounting period (some throughout the period and some at the end) to analyze, record, classify, summarize, and report useful financial information for the purpose of preparing financial statements. In bookkeeping, the accounting period is the period for which the books are balanced and the financial statements are prepared. Generally, the accounting period consists of 12 months. However, the beginning of the accounting period differs according to the company. For example, one company may use the regular calendar year, January to December, as the accounting year, while another entity may follow April to March as the accounting period.

Eight Steps in the Accounting Cycle

There are eight steps in the accounting cycle and they are as follows:

• Analyze transactions by examining source documents.
• Journalize transactions in the journal.
• Post journal entries to the accounts in the ledger.
• Prepare a trial balance of the accounts and complete the worksheet (includes adjusting entries).
• Prepare financial statements.
• Journalize and post adjusting entries.
• Journalize and post closing entries.
• Prepare a post-closing trial balance.

Source Documents

To begin the accounting cycle, it is necessary to understand what constitutes a business transaction. Business transactions are measurable events that affect the financial condition of a business. Business transactions can be the exchange of goods for cash between the business and an external party, such as the sale of a book, or they can involve paying salaries to employees. These events have one fundamental thing in common: they have caused a measurable change in the amounts in the accounting equation, assets = liabilities + stockholders’ equity. The evidence that a business event has occurred is a source document. Sales tickets, checks, and invoices are common source documents. Source documents are important because they are the ultimate proof that a business transaction has taken place.

After determining, via the source documents, that an event is a business transaction, it is then entered into the company books via a journal entry. After all the transactions for the period have been entered into the appropriate journals, the journals are posted to the general ledger . The trial balance proves that the books are in balance or that the debits equal the credits. From the trial balance, a company can prepare their financial statements. After the financials are prepared, the month end adjusting and closing entries are recorded (journalized) and posted to the appropriate accounts. After those entries are made, a post-closing trial balance is run. The post-closing trial balance verifies the debits equal the credits and that all beginning balances for permanent accounts are in place.

Highland Yoga

As we walk through the steps of the accounting cycle, consider the following example. After a number of years as a successful CPA at a national firm, you decide to quit the rat race and pursue your true love — yoga. You decide that Atlanta’s Virginia-Highland neighborhood would be the perfect place to open an Ashtanga Yoga studio. Even better, your friend Solomon, a certified instructor, has just moved to town and is willing to teach at the studio. You hurriedly prepare to open the studio, Highland Yoga, by July 1.

Pre-opening (before July 1)

Prior to opening the business, you make the following transactions:

1. You contribute $4,000 in cash to start the business.

2. You purchase $500 worth of mats and other equipment for use during classes.

3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.

4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.

July

The following transactions take place during July.

1. You receive cash totaling $800 for classes.

2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.

3. You pay rent for July of $1,000 on July 1.

4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.

August

The following transactions take place during August.

1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September.

2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.

3. Utilities total $150, payable September 15.

4. You pay rent of $1,000 on August 1.

5. You sell inventory costing $150 for a revenue of $225.

6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn’t say when.

7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15.

8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.

2.2.2: Recording Transactions

Learning Objective

Explain why the double entry system is used in accounting and the proper use of a T-account

Key Points

• Source documents are important because they are the ultimate proof a business transaction has occurred.
• An account is a part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, stockholders’ equity item, dividend, revenue, and expense.
• The accounting requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure.
• This double-entry procedure keeps the accounting equation in balance.

Key Terms

debit

an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts

account

A registry of pecuniary transactions; a written or printed statement of business dealings or debts and credits, and also of other things subjected to a reckoning or review

credit

an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts

Example

• Continuing our example, how would we recognize and record the transactions involved in running our yoga studio? Pre-openingPrior to opening the business, you make the following transactions:1. You contribute $4,000 in cash to start the business.Cash 4,000, Contributed Capital 4,000; Assets(+)=Equity(+)2. You purchase $500 worth of mats and other equipment for use during classes.Cash -500, PPE 500; Assets(+), Assets(-)=03. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.Cash -400, Inventory 400; Assets(+), Assets(-)=04. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.Cash -1,200, Prepaid Insurance 1,200; Assets(+), Assets(-)JulyThe following transactions take place during July.1. You receive cash totaling $800 for classes.Cash 800, Service Revenue 800; Assets(+)= Equity(+)2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.Cash -300, Wage Payable 300, Instructor Expense 600; Assets(-300)=Liabilities(+300)+Equity(-600)3. You pay rent for July of $1,000 on July 1. Cash -1,000, Rent Expense 1,000; Assets(-)=Equity(-)4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.Utility Payable 200, Utility Expense 200; Liability(+)+Equity(-)=0. AugustThe following transactions take place during August.1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September.Cash 1,500, Unearned Revenue 250, Service Revenue 1,250 Assets(+1,500)=Liability(+250)+Equity(+1,250)2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.Cash -300, Wage Payable 300, Instructor Expense 600; Assets(-300)=Liabilities(+300)+Equity(-600)3. Utilities total $150, payable September 15.Utility Payable 150, Utility Expense 150; Liability(+)+Equity(-)=04. You pay rent of $1,000 on August 1.Cash -1,000, Rent Expense 1,000; Assets(-)=Equity(-)5. You sell inventory costing $150 for a revenue of $225.a. Cash 225, Sales Revenue 225; Assets(+)=Equity(+)b. Inventory -150, Cost of Goods Sold 150; Assets(-)=Equity(-)6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn’t say when.Cash 2,000, Loan Payable 2,000; Assets(+)=Liabilities(+)7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, youagree. The class cost $15.Cash -15, Service Revenue -15; Assets(-)=Equity(-)8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue otheropportunities. You decide to withdraw $1,000.Cash -1,000, Contributed Capital -1,000; Assets(-)=Equity(-)

Journal entries are business transactions that cause a measurable change in the accounting equation.

(Assets = Liabilities + Stockholders’ Equity)

Since business transactions always generate documentation, it is the accountant or bookkeeper’s job to analyze the source document to determine whether a journal entry is necessary. Source documents are important because they are the ultimate proof of business transactions. Some examples of source documents include bills received from suppliers for goods or services received, bills sent to customers for goods sold or services performed, and cash register tapes. Each source document is analyzed to determine whether the event caused a measurable change in the accounting equation. If it has, then it is necessary to prepare and record a journal entry in the proper account.

An account is the part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, stockholders’ equity item, dividend, revenue, and expense. Firms set up accounts for each different business element, such as cash, accounts receivable, and accounts payable. Individual companies may label their accounts differently.

All accounts have corresponding contra accounts depending on what transaction has taken place; i.e., when a vehicle is purchased using cash, the asset account “Vehicles” is debited as the vehicle account increases, and simultaneously the asset account “Bank” is credited due to the payment of the vehicle using cash. Some balance sheet items have corresponding contra accounts, with negative balances, that offset them. Examples are accumulated depreciation against equipment, and allowance for bad debts against long-term notes receivable.

The accounting requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure. This double-entry procedure keeps the accounting equation in balance. For each business transaction recorded, the total dollar amount of debits must equal the total dollar amount of credits. If one account (or accounts) is debited for $100, then another account (or accounts) must be credited for the same amount.

T-accounts

The general ledger of all accounts is, simply, a comprehensive collection of T-accounts — so called because there is a vertical line in the middle of each ledger page and a horizontal line at the top of each ledger page, like a large letter T. The account title will appear above the horizontal line, and debits and credits will appear to the left and right of the vertical line, respectively.

Some typical accounts and their normal balances:

Assets Debit

Contra Asset Credit

Liability Credit

Contra Liability Debit

Owner’s Equity Credit

Stockholder’s Equity Credit

Revenue Credit

Contra Revenue Debit

Expenses Debit

Gains Credit

Losses Debit

An account’s normal balance will be the side on which increases are recorded. For example, assets and expenses normally have debit balances, and liabilities and revenues normally have credit balances.

Continuing our example, how would we recognize and record the transactions involved in running our yoga studio?

Pre-opening

Prior to opening the business, you make the following transactions:

1. You contribute $4,000 in cash to start the business.

Cash 4,000, Contributed Capital 4,000; Assets(+)=Equity(+)

2. You purchase $500 worth of mats and other equipment for use during classes.

Cash -500, PPE 500; Assets(+), Assets(-)=0

3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.

Cash -400, Inventory 400; Assets(+), Assets(-)=0

4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.

Cash -1,200, Prepaid Insurance 1,200; Assets(+), Assets(-)

July

The following transactions take place during July.

1. You receive cash totaling $800 for classes.

Cash 800, Service Revenue 800; Assets(+)= Equity(+)

2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.

Cash -300, Wage Payable 300, Instructor Expense 600; Assets(-300)=Liabilities(+300)+Equity(-600)

3. You pay rent for July of $1,000 on July 1.

Cash -1,000, Rent Expense 1,000; Assets(-)=Equity(-)

4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.

Utility Payable 200, Utility Expense 200; Liability(+)+Equity(-)=0.

August

The following transactions take place during August.

1. You receive $1,500 in cash for classes on August 1. Of this amount, $1,000 is for an initiation fee. The remainder is for 2-month passes allowing unlimited classes in August and September.

Cash 1,500, Unearned Revenue 500, Service Revenue 1,000; Assets(+1,500)=Liability(+500)+Equity(+1,000)

2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.

Cash -300, Wage Payable 300, Instructor Expense 600; Assets(-300)=Liabilities(+300)+Equity(-600)

3. Utilities total $150, payable September 15.

Utility Payable 150, Utility Expense 150; Liability(+)+Equity(-)=0

4. You pay rent of $1,000 on August 1.

Cash -1,000, Rent Expense 1,000; Assets(-)=Equity(-)

5. You sell inventory costing $150 for a revenue of $225.

a. Cash 225, Sales Revenue 225; Assets(+)=Equity(+)

b. Inventory -150, Cost of Goods Sold 150; Assets(-)=Equity(-)

6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn’t say when.

Cash 2,000, Loan Payable 2,000; Assets(+)=Liabilities(+)

7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15.

Cash -15, Service Revenue -15; Assets(-)=Equity(-)

8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.

Cash -1,000, Contributed Capital -1,000; Assets(-)=Equity(-)

2.2.3: Journalizing

Learning Objective

Explain the correct procedure for making a journal entry in the General or Special Journal.

Key Points

• Special journals are designed to facilitate the process of journalizing and posting transactions. They are used for the most frequent transactions in a business.
• Journal entries are prepared after examining the source document to see if a business transaction has taken place.
• The total amount debited and the total amount credited should always be equal, thereby ensuring the accounting equation is maintained.

Key Terms

debit

an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts

journalizing

the act of recording bookkeeping entries

Facilitate

To make easy or easier.

credit

an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts

Example

• Consider our example for the yoga studio. How would we record journal entries for each transaction? Pre-openingPrior to opening the business, you make the following transactions:1. You contribute $4,000 in cash to start the business.Cash 4,000 Contributed capital 4,0002. You purchase $500 worth of mats and other equipment for use during classes.PPE 500 Cash 5003. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.Inventory 400 Cash 4004. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.Prepaid insurance 1,200 Cash 1,200JulyThe following transactions take place during July.1. You receive cash totaling $800 for classes.Cash 800 Revenue 8002. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.Wage expense 600 Cash 300 Wage payable 3003. You pay rent for July of $1,000 on July 1.Rent expense 1,000 Cash 1,0004. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.Utility expense 200 Utility payable 200AugustThe following transactions take place during August.1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September.Cash 1,500 Revenue 1,250 Unearned revenue 2502. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.Wage expense 600 Cash 300 Wage payable 3003. Utilities total $150, payable September 15.Utility expense 150 Utility payable 1504. You pay rent of $1,000 on August 1.Rent expense 1,000 Cash 1,0005. You sell inventory costing $150 for a $225.Cash 225 Revenue 225Cost of goods sold 150 Inventory 150(these can be combined into a single entry if you choose.)6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn’t say when.Cash 2,000 Loan Payable 2,0007. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15.Revenue 15 Cash 15or Refund expense 15 Cash 158. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.Contributed capital 1,000 Cash 1,000(this cannot be a dividend, because your balance of retained earnings is negative. )

The General Journal

The general journal is where double entry bookkeeping entries are recorded by debiting one or more accounts and crediting another one or more accounts with the same total amount. The total amount debited and the total amount credited should always be equal, thereby ensuring the accounting equation is maintained.

Depending on the business’s accounting information system, specialized journals may be used in conjunction with the general journal for record-keeping. In such case, use of the general journal may be limited to non-routine and adjusting entries

Special Journals

Special journals are designed to facilitate the process of journalizing and posting transactions. They are used for the most frequent transactions in a business. For example, in merchandising businesses, companies acquire merchandise from vendors and then in turn sell the merchandise to individuals or other businesses. Sales and purchases are the most common transactions for merchandising businesses. A business like a retail store will record the following transactions many times a day for sales on account and cash sales.

Journalizing

Items are entered the general journal or the special journals via journal entries, or journalizing. Journal entries are prepared after examining the source document to see if a business transaction has taken place. If a business transaction has taken place, that is a transaction that causes a measurable change in the accounting equation then a journal entry is necessary . Each journal entry must have a debit and a credit. Journal entries also include the date of the transaction, titles of the accounts debited and credited (credited account is indented several spaces), the amount of each debit and credit; and an explanation of the transaction also known as a Narration.

Consider our example for the yoga studio. How would we record journal entries for each transaction?

Pre-opening

Prior to opening the business, you make the following transactions:

1. You contribute $4,000 in cash to start the business.

Cash 4,000

Contributed capital 4,000

2. You purchase $500 worth of mats and other equipment for use during classes.

PPE 500

Cash 500

3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.

Inventory 400

Cash 400

4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.

Prepaid insurance 1,200

Cash 1,200

July

The following transactions take place during July.

1. You receive cash totaling $800 for classes.

Cash 800

Revenue 800

2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.

Wage expense 600

Cash 300

Wage payable 300

3. You pay rent for July of $1,000 on July 1.

Rent expense 1,000

Cash 1,000

4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.

Utility expense 200

Utility payable 200

August

The following transactions take place during August.

1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September.

Cash 1,500

Revenue 1,250

Unearned revenue 250

2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.

Wage expense 600

Cash 300

Wage payable 300

3. Utilities total $150, payable September 15.

Utility expense 150

Utility payable 150

4. You pay rent of $1,000 on August 1.

Rent expense 1,000

Cash 1,000

5. You sell inventory costing $150 for a $225.

Cash 225

Revenue 225

Cost of goods sold 150

Inventory 150

(these can be combined into a single entry if you choose. )

6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn’t say when.

Cash 2,000

Loan Payable 2,000

7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15.

Revenue 15

Cash 15

or

Refund expense 15

Cash 15

8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.

Contributed capital 1,000

Cash 1,000

(this cannot be a dividend, because your balance of retained earnings is negative. )

2.2.4: Posting

Learning Objective

Describe how posting affects the General Journal, Special Journal and General Ledger

Key Points

• Posting is always from the journal to the ledger accounts.
• Postings can be made at the time the transaction is journalized; at the end of the day, week, or month; or as each journal page is filled.
• Cross-indexing is the placing of the account number of the ledger account in the general journal and the general journal page number in the ledger account.

Key Terms

general journal

where double entry bookkeeping entries are recorded by debiting one or more accounts and crediting another one or more accounts with the same total amount

posting

an item inserted into a register, ledger or diary

ledger

A book for keeping notes, especially one for keeping accounting records. (accounting) A collection of accounting entries consisting of credits and debits.

Example

• Continuing with our yoga studio example, posting journalized entires into T-accounts would look something like this:

In accounting, each journal entry is like a set of instructions. Carrying out of these instructions is known as posting, a procedure that takes information recorded via journal entries (or journalizing) in the General or Special Journals and transfers it to the General Ledger. Each individual journal entry directs the input of a certain dollar amount as a debit in a specific ledger account, and directs the input of a certain dollar amount as a credit in a specific ledger account. Posting is always from the journal to the ledger accounts, and can be done two ways: the journal entries can be posted at the time the transaction is journalized; or the posting can be done at a set time like the end of the day, week, or month. Journal entries may also be posted as the journal page is filled if using a manual accounting system as a matter of personal taste. When posting the general journal, the date used in the ledger accounts is the date the transaction was recorded in the journal, not the date the journal entry was posted to the ledger accounts.

Since accountants and bookkeepers often need to trace the origin of a ledger entry, they use cross-indexing. In cross-indexing a notation is made for each entry that indicates which general or special journal account the general ledger entry came from. This practice makes it easy to trace an entry back to the original transaction. The account number appears in the Posting Reference column of the General Journal.

2.2.5: The Trial Balance

Learning Objective

Identify when the trial balance is performed and its purpose

Key Points

• A trial balance is prepared after all the journal entries for the period have been recorded.
• The trial balance lists all of the ledger, both general journal and special, accounts and their debit or credit balances.
• A trial balance only checks the sum of debits against the sum of credits. If debits do not equal credits then the accountant or bookkeeper must determine why.

Key Terms

equality

The fact of being equal; of having the same value.

credit

an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts

debit

an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts

Example

• In the example of Highland Yoga, the pre-opening trial balance would be calculated as follows:1. You contribute $4,000 in cash to start the business.Cash 4,000, Contributed Capital 4,000; Assets(+)=Equity(+)2. You purchase $500 worth of mats and other equipment for use during classes.Cash -500, PPE 500; Assets(+), Assets(-)=03. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.Cash -400, Inventory 400; Assets(+), Assets(-)=04. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December 31.Cash -1,200, Prepaid Insurance 1,200; Assets(+), Assets(-)The trial balance for debits will be:4,000 (cash) + 500 (PPE) + 400 (inventory) + 1,200 (prepaid insurance) = 6,100The trial balance for credits will be:4,000 (contributed capital) + 500 (cash) + 400 (cash) + 1,200 (cash) = 6,100The calculation will be the same for the next two periods in the example, including any necessary adjustments.

The Trial Balance

During the accounting cycle, a trial balance is prepared. It is usually prepared after all the journal entries for the period have been recorded.

The trial balance tests the equality of a company’s debits and credits. It lists all of the ledger, both general journal and special, accounts and their debit or credit balances to determine that debits equal credits in the recording process .

The accounts appear in this order: assets, liabilities, stockholders’ equity, dividends, revenues, and expenses. Within the assets category, the most liquid (closest to becoming cash) asset appears first and the least liquid appears last. Within the liabilities, those liabilities with the shortest maturities appear first.

If the total of the debit column does not equal the total value of the credit column then this would show that there is an error in the nominal ledger accounts. This error must be found before a profit and loss statement and balance sheet can be produced.

Preparing the Trial Balance

The trial balance is usually prepared by a bookkeeper or accountant. The bookkeeper/accountant used journals to record business transactions. The journal entries were then posted to the general ledger. The trial balance is a part of the double-entry bookkeeping system and uses the classic ‘T’ account format for presenting values. A trial balance only checks the sum of debits against the sum of credits. If debits do not equal credits then the accountant or bookkeeper must determine why.

In the example of Highland Yoga, the pre-opening trial balance would be calculated as follows:

1. You contribute $4,000 in cash to start the business.

Cash 4,000, Contributed Capital 4,000; Assets(+)=Equity(+)

2. You purchase $500 worth of mats and other equipment for use during classes.

Cash -500, PPE 500; Assets(+), Assets(-)=0

3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.

Cash -400, Inventory 400; Assets(+), Assets(-)=0

4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December 31.

Cash -1,200, Prepaid Insurance 1,200; Assets(+), Assets(-)

The trial balance for debits will be:

4,000 (cash) + 500 (PPE) + 400 (inventory) + 1,200 (prepaid insurance) = 6,100

The trial balance for credits will be:

4,000 (contributed capital) + 500 (cash) + 400 (cash) + 1,200 (cash) = 6,100

The calculation will be the same for the next two periods in the example, including any necessary adjustments.

Finding Errors in the Trial Balance

Some reasons why the general ledger may be out of balance:

• Failing to post part of a journal entry.
• Posting a debit as a credit, or vice versa.
• Incorrectly determining the balance of an account.
• Recording the balance of an account incorrectly in the trial balance.
• Omitting an account from the trial balance.
• Making a transposition or slide error in the accounts or the journal.

When the error is found, a correcting entry must be made. Then another trial balance is run.

2.2.6: Adjustments

Learning Objective

Identify the types of adjusting entries and when and why they are made

Key Points

• The matching principle of accrual accounting demands that revenues and associated costs are recognized in the same accounting period.
• The types of adjusting entries are prepayments, accrual, estimates, and inventory.
• Depreciation is an example of an estimated adjusting entry.
• In a periodic inventory system, an adjusting entry is used to determine the cost of goods sold expense. However, an adjusting entry is not necessary for a company using perpetual inventory.
• Adjusting entries for expenses such as interest, taxes, rent, and salaries are the most common accrual entries.

Key Terms

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

accrue

(intransitive, accounting) To be incurred as a result of the passage of time.The monthly financial statements show all the actual but only some of the accrued expenses.

Example

• Consider our yoga studio example. Some of our previously recognized transactions need to be adjusted in later periods:Julya. Recognize insurance expensePrepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)b. Depreciation @ $20/monthAccumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)Augusta. Recognize insurance expensePrepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)b. Depreciation @ $20/monthAccumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)c. Pay wages from JulyCash -300, Wage Payable -300; Assets(-), Liabilities(-)d. Pay utilities from JulyCash -200, Utility Payable -200; Assets(-), Liabilities(-) The journal entries to record these transactions would be as follows:Julya. Expiration of insuranceInsurance expense 200 Prepaid insurance 200b. Depreciation on studio equipment (500 for 25 months = 20/month)Depreciation expense 20 Accumulated Depreciation 20Augusta. Expiration of insuranceInsurance expense 200 Prepaid insurance 200b. Depreciation on studio equipment (500 for 25 months = 20/month)Depreciation expense 20 Accumulated Depreciation 20c. Pay wage from JulyWage payable 300 Cash 300d. Pay utility bill from JulyUtility payable 200 Cash 200

What are Adjusting Entries

For accounting purposes, adjusting entries are journal entries made at the end of an accounting period. Adjusting entries allocate income and/or expenses to the period in which they actually occurred . The revenue recognition principle states that income and expenses must match. This is why adjusting entries need to be made under an accrual based accounting system. Based on this, revenues and associated costs are recognized in the same accounting period. However, the actual cash may be received or paid at a different time.

The Types of Adjusting Entries

There are several different types of adjusting entries. Each one accounts for a different situation.

• Prepayments – adjusting entries for prepayments are necessary to account for cash that has been paid prior to delivery of goods or completion of services. When this cash is paid, it is first recorded in a prepaid expense asset account; the account is to be expensed either with the passage of time (e.g. rent, insurance) or through use and consumption (e.g. supplies). The adjusting entry would credit the asset (e.g. supplies) account and debit a related expense account (e.g. supplies expense)
• Accruals – accrued revenues are revenues that have been recognized (that is, services have been performed or goods have been delivered), but their cash payment have not yet been recorded or received. When the revenue is recognized, it is recorded as a receivable. Accrued expenses have not yet been paid for, so they are recorded in a payable account. Expenses for interest, taxes, rent, and salaries are commonly accrued for reporting purposes.
• Estimates – An adjusting entry for an estimate occurs when the exact amount of an expense cannot easily be determined. For example, the depreciation of fixed assets is an expense that has to be estimated. The entry for bad debt expense can also be classified as an estimate.
• Inventory – in a periodic inventory system, an adjusting entry is used to determine the cost of goods sold expense. This entry is not necessary for a company using perpetual inventory.

Consider our yoga studio example. Some of our previously recognized transactions need to be adjusted in later periods:

July

a. Recognize insurance expense

Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)

b. Depreciation @ $20/month

Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)

August

a. Recognize insurance expense

Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)

b. Depreciation @ $20/month

Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)

c. Pay wages from July

Cash -300, Wage Payable -300; Assets(-), Liabilities(-)

d. Pay utilities from July

Cash -200, Utility Payable -200; Assets(-), Liabilities(-)

The journal entries to record these transactions would be as follows:

July

a. Expiration of insurance

Insurance expense……………………………….200

—–Prepaid insurance……………………………………200

b. Depreciation on studio equipment (500 for 25 months = 20/month)

Depreciation expense……………………………20

—–Accumulated Depreciation……………………………20

August

a. Expiration of insurance

Insurance expense……………………………200

—–Prepaid insurance ……………………………200

b. Depreciation on studio equipment (500 for 25 months = 20/month)

Depreciation expense……………………………20

—–Accumulated Depreciation……………………20

c. Pay wage from July

Wage payable……………………………300

—–Cash…………………………………………300

d. Pay utility bill from July

Utility payable……………………………200

—–Cash………………………………………….200

2.2.7: Preparing Financial Statements

Learning Objective

Explain the necessary steps to take before preparing the financial statements and the purpose of the statements

Key Points

• The purpose of financial statements are to provide both business insiders and outsiders a concise, clear picture of the current financial status in the business. Therefore, the people who use the statements must be confident in its accuracy.
• Closing the books is simply a matter of ensuring that transactions that take place after the business’s financial period are not included in the financial statements.
• Adjusting entries are generally made in relation to prepaid expenses, prepayments, accruals, estimates and inventory.
• When an audit is completed, the auditor will issue a report regarding whether the statements are accurate. To ensure a positive reports, some companies try to participate in opinion shopping. This practice is generally prohibited..

Key Terms

audit

An independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures

adjusting entry

Journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred.

opinion shopping

The process of contracting or rejecting auditors based on the type of opinion report they will issue on the auditee.

Example

• Financial statements for Highland Yoga for each period would appear as follows:

Preparing Financial Statements

When a business enterprise presents all the relevant financial information in a structured and easy to understand manner, it is called a financial statement. The purpose of financial statements are to provide both business insiders and outsiders a concise, clear picture of the current financial status in the business. Therefore, the people who use the statements must be confident in its accuracy.

Adjusted Trial Balance – Closing the Books

The process of preparing the financial statements begins with the adjusted trial balance. Preparing the adjusted trial balance requires “closing” the book and making the necessary adjusting entries to align the financial records with the true financial activity of the business.

Closing the books is simply a matter of ensuring that transactions that take place after the business’s financial period are not included in the financial statements. For example, assume a business is preparing its financial statements with a December 31^st year end. It acquires some property on January 14th. If the books are properly closed, that property will not be included on the balance sheet that is being prepared for the period on December 31st.

Adjusted Trial Balance – Adjusting Entries

An adjusting entry is a journal entry made at the end of an accounting period that allocates income and expenditure to the appropriate years. Adjusting entries are generally made in relation to prepaid expenses, prepayments, accruals, estimates and inventory. Throughout the year, a business may spend funds or make assumptions that might not be accurate regarding the use of a good or service during the accounting period. Adjusting entries allow the company to go back and adjust those balances to reflect the actual financial activity during the accounting period. Failure to record the adjusting entries can result in understatement of expenses and overstatement of income, which ultimately can affect the amount of taxes paid.

For example, assume a company purchases 100 units of raw material that it expects to use up during the current accounting period. As a result, it immediately expenses the cost of the material. However, at the end of the year the company discovers it only used 50 units. The company must then make an adjusting entry to reflect that, and decrease the amount of the expense and increase the amount of inventory accordingly.

Translate the Adjusted Trial Balance to Financial Statements

Using the trial balance, the company then prepares the four financial statements. These statements are:

• The Balance Sheet: A summary of the company’s assets, liabilities and equity;
• The Income Statement: A summary of the business’s income, expenses, and profits
• The Statement of Cash Flows: A report on a company’s cash flow activities, particularly its operating, investing and financing activities; and
• The Statement of Changes in Equity: A report that explains the changes of the company’s equity throughout the reporting period

Information flows from the unadjusted trial balance to the trial balance then to the income statement.

The company may also provide Notes to the Financial Statements, which are disclosures regarding key details about the company’s operations that may not be evident from the financial statements.

Audit the Financial Statements

Once the company prepares its financial statements, it will contract an outside third party to audit it. An audit is an independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures. It is the audit that assures outside investors and interested parties that the content of the statements are correct.

When an audit is completed, the auditor will issue a report with the findings. The findings can state anything from the statements are accurate to statements are misleading. To ensure a positive reports, some companies try to participate in opinion shopping. This is the process that businesses use to ensure it gets a positive review. Since Enron and the accounting scandals of the early 2000s, this practice has been prohibited.

2.2.8: Closing the Cycle

Learning Objective

Identify the steps in the closing process

Key Points

• Closing may be performed monthly or annually.
• There are four basic steps to closing the books.
• Closing the revenue accounts—transferring the balances in the revenue accounts to a clearing account called Income Summary.
• Closing the expense accounts—transferring the balances in the expense accounts to a clearing account called Income Summary.
• Closing the Income Summary account—transferring the balance of the Income Summary account to the Retained Earnings account (also known as the capital account).
• Closing the Dividends account—transferring the balance of the Dividends account to the Retained Earnings Account.

Key Terms

temporary account

an account that is closed at the end of the period to be made a permanent account

revenue

Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.

account

A registry of pecuniary transactions; a written or printed statement of business dealings or debts and credits, and also of other things subjected to a reckoning or review

Example

• Closing entries for our yoga studio example would be:

Closing the Accounting Cycle

The process of closing the temporary accounts is often referred to as closing the books. Accountants may perform the closing process monthly or annually. Only revenue, expense, and dividend accounts are closed—not asset, liability, Capital Stock, or Retained Earnings accounts. If the accounts are not closed correctly the beginning balances for the next month may be incorrect.

The Steps to Close the Accounts

There are four basic steps in the closing process:

• Closing the revenue accounts—transferring the balances in the revenue accounts to a clearing account called Income Summary.
• Closing the expense accounts—transferring the balances in the expense accounts to a clearing account called Income Summary.
• Closing the Income Summary account—transferring the balance of the Income Summary account to the Retained Earnings account (also known as the capital account).
• Closing the Dividends account—transferring the balance of the Dividends account to the Retained Earnings Account

The Income Summary account is a clearing account only used at the end of an accounting period to summarize revenues and expenses for the period. After transferring all revenue and expense account balances to Income Summary, the balance in the Income Summary account represents the net income or net loss for the period. Closing or transferring the balance in the Income Summary account to the Retained Earnings account results in a zero balance in the Income Summary. The Dividends account is also closed at the end of the accounting period. It contains the dividends declared by the board of directors to the stockholders. The dividends account is closed directly to the Retained Earnings account. It is not closed to the Income Summary because dividends have no effect on income or loss for the period.

2.2.9: The Post-Closing Trial Balance

Learning Objective

Explain the post-closing trial balance and why it is necessary

Key Points

• A post-closing trial balance checks the accuracy of the closing process.
• A post-closing trial balance proves that the books are in balance at the start of the new accounting period.
• The post-closing trial balance differs from the adjusted trial balance.

Key Terms

adjusted trial balance

a list of all the General ledger accounts (both revenue and capital) contained in the ledger of a business after adjusting entries are made

trial balance

a statement of the balances of all nominal accounts in a double-entry ledger, made to test their equality

credit

an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts

closing entry

a journal entry made at the end of an accounting period to transfer temporary accounts to permanent accounts

debit

an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts

post-closing trial balance

a check that closing entries were done correctly

The Post-closing Trial Balance

The post-closing trial balance is the last step in the accounting cycle. It is prepared after all of that period’s business transactions have been posted to the General Ledger via journal entries. The post-closing trial balance can only be prepared after each closing entry has been posted to the General Ledger. The purpose of closing entries is to transfer the balances of the temporary accounts (expenses, revenues, gains, etc.) to the retained earnings account. After the closing entries are posted, these temporary accounts will have a zero balance. The permanent balance sheet accounts will appear on the post-closing trial balance with their balances. When the post-closing trial balance is run, the zero balance temporary accounts will not appear. However, all the other accounts having non-negative balances are listed, including the retained earnings account. As with the trial balance, the purpose of the post-closing trial balance is to ensure that debits equal credits.

Why the Post-Closing Trial Balance Is Necessary

While each accounting period has a beginning and an end, the periods do use information from the previous period. That is why it is necessary to run a post-closing trial balance. The preparation of a post-closing trial balance serves as a check on the accuracy of the closing process and ensures that the books are in balance at the start of the new accounting period. The post-closing trial balance differs from the adjusted trial balance in only two important respects: It excludes all temporary accounts since they have been closed, and it updates the retained earnings account to its proper ending balance.

2.2.10: Reversing Entries

Learning Objective

Describe why and how a reversing entry is made

Key Points

• Reversing entries are optional, and some firms do not perform them.
• A reversing entry reverses an adjusting entry exactly.
• Reversing entries are performed because they reduce errors and save time.

Key Terms

debit

an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts

credit

an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts

Example

• In the example of Highland Yoga, adjusting entries are made at the end of July and August. One such entry, at the end of July, is as follows: Expiration of insurance Insurance expense 200 Prepaid insurance 200 At the beginning of August, if Highland Yoga chooses to adopt reversing entries, such an entry would be as follows: Reversing of insurance 200 Prepaid insurance 200

Reversing Entries

Reversing entries are journal entries made at the beginning of each accounting period. The sole purpose of a reversing entry is to cancel out a specific adjusting entry made at the end of the prior period, but they are optional and not every company uses them. Most often, the entries reverse accrued revenues or expenses for the previous period. Some examples of reversing entries are salary or wages payable and interest payable.

How Reversing Entries Are Used

Reversing entries help prevent accountants and bookkeepers from double recording revenues or expenses. Reversing entries are most often used with accrual-type adjusting entries.

How a Reversing Entry Works

The goal of the reversing entry is to ensure that an expense or revenue is recorded in the proper period. For example, when a company takes out a loan. If the loan is issued on the sixteenth of month A with interest payable on the fifteenth of the next month (month B), each month should reflect only a portion of the interest expense. To get the expense correct in the general ledger, an adjusting entry is made at the end of the month A for half of the interest expense. This adjusting entry records months A’s portion of the interest expense with a journal entry that debits interest expense and credits interest payable. At the beginning of the month B that expense is reversed via a reversing entry. The entry credits interest expense and debits interest payable. When the full amount of the interest is paid in month B, each month’s books will show the proper allocation of the interest expense.