Deze samenvatting is gebaseerd op het studiejaar 2013-2014.
Accounting is an information system that measures, processes, and communicates financial information about an identifiable economic entity. A business is an economic unit that aims to sell goods and services to customers at prices that will provide an adequate return to its owners. Their need to earn enough income to attract and hold investment capital is the goal of profitability. In addition, business must meet the goal of liquidity: having enough cash available to pays debts when they are due.
Businesses pursue their goals by engaging in the following activities:
Operating activities such as selling goods and services to customers, and the buying and producing of goods.
Investing activities such as buying land
Financing activities like obtaining capital from owners and from creditors such as banks.
An important function of accounting is to provide performance measures, which indicate whether managers are achieving their business goals and whether business activities are well managed. Management accounting is the internal managing of finance. Financial accounting generates reports and communicates them to the external decision makers. These reports are called financial statements. Bookkeeping is only a small part of accounting. As fraudulent financial reports can have serious consequences, ethical financial reporting is important.
The people who use the accounting data are the management, users with direct financial interest and users with indirect financial interest. Users with direct financial interest are for example investors or creditors. Users who have indirect financial interest are tax authorities, regulatory agencies and other groups such as labour unions.
To make an accounting measurement, the accountant must answer four basic questions:
What is measured?
When should the measurement be made?
What value should be placed on what is measured?
How should what is measured be classified?
Business transactions are economic events that affect a business’s financial position. Transactions are recorded in terms of money: money measure. For accounting purposes, a business is a separate entity, distinct not only from its creditors and customers but also from its owners. It should have a completely separate set of records, and its financial records and reports should refer only to its own financial affairs.
Three forms of enterprises:
A sole proprietorship is a business owned by one person. The person is liable for all obligations of the business.
A partnership has two or more owners. The owners share the profits and losses.
A corporation is a business unit chartered by the state and legally separated from its owners (the stockholders). Because they have limited involvement in the corporation, their risk of loss is limited to the amount they paid for their shares.
To form a corporation, an application must be signed with the proper state official. This contains the articles of incorporation. The authority to manage the corporation is delegated by the stockholders to the board of directors and then to the management. A unit of ownership in a corporation is called a share of stock. A board of directors is elected by the stockholders. They appoint managers to carry out the day-to-day work. Only the board has the authority to declare dividends. Dividends are distributions of resources, usually in the form of cash, to the stockholders.
Corporate governance is the oversight of a corporation’s management and ethics by its board of directors. To strengthen corporate governance, an audit committee made up of independent directors who have financial expertise, is appointed by the board of directors.
Financial position and the accounting equation.
Financial position refers to the economic resources that belong to a company and the claims against those resources at a particular time. Another term for claims is equities. As every corporation has two types of equities: creditors’ equities and stockholders’ equity, the following equation holds::
Economic Resources = Creditors’ Equities + Stockholders’ Equities.
In accounting terminology the economic resources are also called assets and creditors’ equities are called liabilities. This gives the accounting equation:
Assets = Liabilities + Stockholders’ Equity
Examples of assets are: monetary items as cash and non monetary items such as inventory and land. Liabilities are present obligations of a business to pay cash, transfer assets, or provide services to other entities in the future. Among them are debts, amounts owed to suppliers to borrowed money. The owner’s equity is called the stockholder’s equity. It has two parts, the amount that stockholders invest in the business: contributed capital, and the equity of the stockholders generated from the income-producing activities of the business and kept in use in the business: retained earnings. Revenues and expenses are the increases and decreases in stockholder’s equity that result from operating a business. Retained earnings can therefore increase because of revenues and decrease because of expenses and the payment of dividends.
Four major financial statements:
The income statement focuses on the company’s profitability. It summarizes the revenue earned and expenses incurred by a business over a period of time. This will give the net income.
The statement of retained earnings shows the changes in retained earnings over a period of time. It is the difference between the old and the new net income, less the dividends.
The balance sheet presents a view of the business as the holder of the resources, or assets, that are equal to the claims against those assets. On the left side are the assets, on the right the liabilities and the stockholder’s equity. Both sides should be equal.
The statement of cash flows is directed toward the company’s liquidity goal. The outcome of the cash flows statement should be equal to the amount of cash on the balance sheet.
To ensure that financial statements are understandable for their users, generally accepted accounting principles (GAAP) have been developed. They provide guidelines for financial accounting.
To measure a business transaction, the accountant must decide when the transaction occurred (the recognition issue), what value to place on the transaction (the valuation issue), and how the components of the transaction should be categorized (the classification issue).
The predetermined time at which a transaction should be recorded is the recognition point. This is when a company receives a product, buys a service or pays an employee. When a company just orders a product and hasn’t received the bill or the product, there is no transaction yet. A monetary value is assigned to a business transaction. This value should be equal to the original cost, the exchange price. The classification issue has to do with assigning transactions to appropriate accounts. Recognition, valuation, and classification are important factors in ethical financial reporting, and GAAP provide direction about their treatment.
The system to record transactions is called the double-entry system. Each transaction must be recorded with at least one debit and one credit equal to each other. This way the whole system is in balance. The T account has three parts: a title, a left side which is called the debit side, and a right side called the credit side.
The accounting equation was:
Assets = Liabilities + Stockholder’s equity
This means that when a debit is made on the assets side, a credit should be made on the liabilities or stockholder’s equity side.
The trial balance adds all the outcomes of balances to see if both sides are equal. It is prepared by listing each account balance in the appropriate Debit or Credit column. The two columns are then added, and the totals compared.
Not all transactions generate immediate cash. Then, there is a holding period in either Accounts Receivable or Accounts Payable before the cash is received or paid.
The chart of accounts is a list of account numbers and titles; it servers as a table of contents for the ledger. The general journal is used to record all transactions chronologically. A separate journal entry is used to record each transaction. It should include:
The names of accounts debited and the dollar amounts on the same lines in the debit column
The names of accounts credited and the dollar amounts on the same lines in the credit column.
An explanation of the transaction
The account identification numbers, if appropriate.
The general ledger has four columns for dollar amounts unlike the journal, which has only two columns. In addition to the two columns, the ledger states the balance of the separate accounts that have been debited or credited.
Net income is the net increase in stockholders’ equity resulting from the operations of a company. Net income = Revenues – Expenses. When there are more expenses than revenues, a net loss occurs. Revenues are increases in stockholders’ equity resulting from the operations of a company such as selling goods. Expenses are decreases in stockholders’ equity resulting from the operations of a company such as the cost of selling goods.
In measuring business income, the following assumptions are made:
The continuity assumption: This assumption is about how long the business entity will last. It is normal for an accountant to assume that the business will continue to operate indefinitely. This means that the business is a going concern.
The periodicity assumption: Some products have effects that extend over many years. Accountants estimate the time the product will be in use and the cost that should be assigned to each year. They make an assumption about periodicity: that although the lifetime of a business is uncertain, it is useful to estimate the business’s net income in terms of accounting periods.
The matching assumption: Revenues and expenses must be accounted for when cash is received and cash is paid. This is called the cash basis of accounting. The matching rule is the following: Revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the accounting period in which they are used to produce revenue.
As applying the matching rule involves making assumptions, it can lead to earnings management: the manipulation of revenues and expenses to achieve a specific outcome. When the estimates involved are moving outside a reasonable range, the financial statements become misleading – and fraudulent.
Accrual accounting encompasses all the techniques accountants use to apply the matching rule. In accrual accounting, revenues and expenses are recorded in the periods in which they occur rather than in the periods in which they are received of paid. Accrual accounting is accomplished in the following ways:
Recognizing revenue when they are earned:
The following conditions must exist before revenue is recognized:
Persuasive evidence of an arrangement exists.
Delivery has occurred or services have been rendered.
The seller’s price to the buyer is fixed of determinable.
Collectibility is reasonably assured.
Recognizing expenses when they are incurred.
Expenses can be recorded when an agreement is made to purchase goods, the goods have been delivered, a price is established, and the goods or services have been sued to produce revenue.
Adjusting the accounts.
This is needed because an accounting period ends on a certain day. Some transactions span this cutoff point, and therefore some accounts need adjustments.
Accountants use adjusting entries to apply accrual accounting to transactions that span more than the accounting period. An accrual is the recognition of a revenue or expense that has happened but hasn’t been recorded yet. This could be wages earned by employees in the current accounting period but after the last pay period. It can also be fees earned but not yet billed to customers. A deferral is the postponement of the recognition of an expense already paid or a revenue received in advance. Examples are prepaid rent or payments collected for services yet to be rendered.
Type 1: Allocating recorded costs between two or more accounting periods. These are called deferred expenses. The expenditures are usually debited to an assent account, and at the end of the period, the amount that has been used will be transferred from the asset account to an expense account.
Example: Adjustment for prepaid rent.
July 31: Expiration of one month’s rent, $ 1600
At the beginning of July, two months’ of rent has been paid in advance. At the end of the month, half of the prepaid rent had expired and should be treated as an expense.
The same can be done for prepaid insurance.
Adjustment for Supplies
July 31: Consumption of supplies, $ 1540
A company can purchase supplies that will be consumed when performing tasks. An example is office supplies. At the end of the month the balance still shows the old amount of office supplies, while inventory shows that a certain amount of supplies has been used.
This should be accounted for in the following way:
Depreciation is also a deferred expense. When office equipment depreciates, a contra account called ‘accumulated depreciation office equipment’, will be created. The balance of this contra account is shown on the financial statement as a deduction from the related account, here the ‘office equipment’ account.
Type 2: Recognizing unrecorded expenses. This is called an accrued expense. Examples of this kind of expense are accrued wages and estimated income taxes.
Example: By the end of business on July 31, an employee will have worked three days (29, 30 and 31 July) beyond the last pay period. The employee has earned wages for those days - $240 per day - but will not be paid until the first payday in August.
These last days should be accounted for in the following way:
The accrual of unrecorded wages is 3 days x $ 240 = $ 720.
The wages expense account is an equity account. The wages payable is a liability account.
The same can be done for income taxes. A company can estimate the amount that will go to income taxes for that month and record this amount as income taxes payable and income taxes expense.
Type 3: Allocating of recorded unearned revenues between two or more accounting periods. These revenues are called deferred revenues. When a company receives a payment in advance, this payment will be recorded as a liability account. At the end of the month, the company should record the part of the job that has been finished under fees earned, a revenue account. Suppose this company received $1400 as advance payment. By the end of the month it had completed $800 of work. This should be recorded in the following way:
Type 4: Recognizing unrecorded earned revenues. These are called accrued revenues. Suppose that a company agreed to design a website, and to have it operational at July 31. By the end of the month, the company had earned $400 for completing the first section, but had not billed this yet.
This should be recorded in the following way:
Balance sheet accounts are permanent accounts, they carry their end-of-period balance into the next period. Revenue and expense accounts are temporary accounts because they begin each period with a balance of zero. Closing entries are journal entries made at the end of an accounting period. They clear the accounts of their balance and they summarize a period’s revenue and expenses. To do this, the balances of the revenue and expense accounts are transferred to the Income Summary account; another temporary account. It is only used for closing entries and does not appear in financial statements. There are four steps in closing accounts:
Closing the credit balances from income statement accounts to the Income Summary account.
Closing the debit balances from income statement accounts to the Income Summary account.
Closing the Income Summary account balance to the Retained Earnings account.
Closing the Dividends account balance to the Retained Earnings account.
Because errors can be made in posting closing entries to the ledger accounts, it is necessary to prepare a post-closing trial balance to determine that all temporary accounts have zero balances and to double check that total debits equal total credits.
The general rule for determining the cash flow received from any revenue or paid for any expense (except depreciation) is to determine the potential cash payments or cash receipts and deduct the amount not paid or received.
Financial reporting is important for three major reasons:
To furnish information that is useful in making investment and credit decisions
To provide information useful in assessing cash flow prospects
To provide information about business resources, claims to those resources, and changes in them.
To help interpret accounting information, the FASB has described qualitative characteristics. The most important ones are understandability and usefulness. The first one depends on the accountant, who has to prepare the statements in accordance with accepted practices, and the decision maker, who must judge what information to use. When accounting information is useful, it must have the characteristics of relevance and reliability. To be relevant, the information must provide feedback, predict future conditions, and be timely. To be reliable, the information must be credible, verifiable and neutral.
Accountants depend on five conventions to help in the interpretation of the financial statements.
Comparability and consistency: The information in a financial statement must be provided in such a way that anyone who reads it can recognize similarities, differences, and trends over time. When a company adopts a certain accounting procedure, it must continue working with this procedure from one period to the next, or inform users when a change occurs. This way the statements are consistent.
Materiality: An item is material if there is a reasonable expectation that knowing about it would influence the decisions of users of the statements. When a small asset is not material, a company could decide to record the asset as an expense, instead of a long-term asset that has to be depreciated.
Conservatism: When accounts face major uncertainties about procedures that they can use, they choose the one that is least likely to overstate assets and income.
Full disclosure: It is required that financial statements present all information that is relevant to the users of the statements.
Cost-benefit: The benefits to be gained from providing accounting information should be greater than the costs of providing it.
Since the passage of the Sarbanes-Oxley Act in 2002, CEO’s and CFO’s have been required to certify the accuracy and completeness of there companies’ financial statements.
The balance sheet
When there are many different accounts in a company, it can be easy to place them into subcategories. Statements that are divided into subcategories are called classified financial statements. Assets are often dividend into:
Current assets: Cash and other assets that are expected to be converted into cash, sold, or consumed within one year, or within the operating cycle, whichever is longer.
Investments: Includes assets, usually long-term, that are not used in the normal operation of the business and that are not planned to be converted into cash within one year.
Property, plant, and equipment: Tangible long-term assets used in the continuing operation of the business. Through depreciation, the costs of the assets are spread over the periods they benefit.
Intangible assets: Long-term assets with no physical substance.
Sometimes investments, intangible assets, and miscellaneous assets are grouped into a category other assets.
Liabilities are divided into two categories. This depends on when the liabilities are due.
Current liabilities: All obligations to be paid within one year, or within the normal operating cycle, whichever is longer.
Long-term liabilities: Debts that fall due more than one year in the future or beyond the normal operating cycle.
The stockholders’ equity section has two parts: contributed capital and retained earnings. When a company is a sole proprietorship, the equity section simply shows the owners’ name at the amount equal to the net assets of the company. There is no need to separate retained earnings and contributed capital. When the company is a partnership, the equity section is divided between the partners.
The income statement
Thus far, the income statement was presented by deducting all expenses from revenue in one step to get to the net income. There is also a multistep income statement. It is used for service companies, merchandise companies, who buy and sell products, and manufacturing companies, who make and sell products. The income statement for the latter two differs from the service company.
Multistep income statement for a service company:
Multistep income statement for a merchandising or manufacturing company:
Net sales: Consists of all gross sales of merchandise, less sales returns and allowances and any discounts. Gross sales consists of total cash sales and total credit sales during an accounting period
Cost of goods sold: The amount paid for the merchandise sold or the cost of making the products sold during the accounting period.
Gross margin: The difference between net sales and cost of goods sold.
Operating expenses: The expenses other than cost of goods sold that are incurred in running a business. Often operating expenses are grouped into categories such as selling expenses and administrative expenses.
Income from operations: The difference between gross margin and operating expenses. This is the income from a company’s normal business.
Other revenues and expenses: Revenues and expenses that are not part of a company’s operating activities. It includes revenues from investments, interest earned on credit or notes, interest expense and other kinds of revenues and expenses.
Income before taxes: The amount a company has earned from all activities before taxes are paid.
Income taxes: The expense for federal, state, and local taxes on corporate income.
Net income: What remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and taxes are deducted. It is the amount that is transferred to retained earnings from all the income-generating activities during the year.
Earnings per share: The net income earned on each share of common stock. The simplest method is dividing the net income by the average number of outstanding stock.
The single-step income statement simply groups all expenses and all revenues and deducts them to get to the income before income taxes. Income taxes are shown as a separate item and are deducted to get to the net income.
Using classified financial statements
Management has two important goals: maintaining adequate liquidity and achieving satisfactory profitability. Ratios make use of the components in classified financial statements to reflect a company’s performance with respect to these important goals.
Liquidity means having enough money on hand to pay bills when they are due and to take care of unexpected needs for cash.
There are two ways to measure it:
Working capital: the amount by which total current assets exceed total current liabilities. By definition, current liabilities are paid out of current assets. It is calculated by deducting current liabilities from current assets.
Current ratio: An indicator of a company’s ability to pay its bills and to repay outstanding loans:
Profitability is the ability to earn a satisfactory income. Liquid assets are not the best profit-producing resources. For example, a company can have enough cash and have purchasing power, but profit can be made only when the purchasing power is used to buy profit-producing (and less liquid) assets, such as inventory and long-term assets. There are five common ways to measure to ability of a company to earn income:
Profit margin: The percentage of each sales dollar that results in net income.
Asset turnover: Measures how efficiently assets are used to produce sales. It shows how many dollars of sales were generated by each dollar of assets:
The profit margin does not look at the assets that are necessary to produce income, and the asset turnover does not look at the amount of income produced. To overcome these limitations, there is the return on assets ratio:
Return on assets: Relates the net income to average total assets. It shows how much net income is generated for each dollar invested.
Return on assets
Debt to equity ratio: Shows the proportion of the company financed by creditors compared to the proportion financed by stockholders. When total liabilities is not stated on the balance sheet, it can be determined by deducting the total stockholders’ equity from total assets.
Assume that the debt to equity percentage is 60%, this means that less than half the financing is from creditors and more than half from investors.
Return on equity: Measures how much stockholders have earned with their investments.
A merchandising business earns income by buying and selling goods, which are called merchandise inventory. They use the same basic accounting methods as service companies, but the buying and selling of goods adds to the complexity of the process.
Merchandising businesses engage in a series of transactions called the operating cycle:
Purchase of merchandise inventory for cash or on credit
Payment for purchases made on credit
Sales of merchandise inventory for cash or on credit
Collection of cash from credit sales
Purchases of merchandise are usually made on credit, so the merchandiser has a period of time before payment is due, but this period is generally less than the time it takes to sell the merchandise. To finance the inventory until it is sold and the resulting revenue is collected, management must plan for cash flows from within the company or from borrowing.
The financing period is the amount of time from the purchase of inventory until it is sold and payment is collected, less the amount of time creditors give the company to pay for the inventory. When a company sells most of its inventory for cash, they have very low receivables, and this decreases the financing period. Example:
Day 0: inventory is purchased
Day 40: Cash paid
Day 60: Inventory sold
Day 120: Cash received
Management must choose the inventory system or combination of systems that is best for achieving the company’s goals. There are two basic systems of accounting for the many items in the merchandise inventory:
The Perpetual inventory system: continuous records are kept of the quantity and, usually, the cost of individual items as they are bought and sold. The cost of each item is recorded in the Merchandise Inventory account when it is purchased. When it is sold, its cost is transferred to the Cost of Goods Sold account.
The periodic inventory system: the inventory not yet sold is counted periodically, usually at the end of the accounting period. No detailed records of the inventory on hand are maintained during the accounting period.
Because of the difficulty and expense of accounting for the purchase and sale of each item, companies that sell items of low value in high volume have traditionally used the periodic inventory system. In contrast, companies that sell items of high unit value have tended to use the perpetual inventory system.
If a company is engaged in international transactions, it must deal with changing exchange rates.
Management’s responsibility is to establish an environment, accounting systems, and control procedures that will protect the company’s assets against theft and embezzlement. These systems are called internal controls. Maintaining control over merchandise inventory is facilitated by taking a physical inventory. This process involves an actual count of all merchandise on hand. Merchandise inventory includes all goods intended for sale that are owned by a business, regardless of where they are located. It also includes goods in transit from suppliers if title to the goods has passed to the merchant. The actual count is usually taken after the close of business on the last day of the fiscal year.
When losses of goods occur (because of spoilage or shoplifting), the cost of goods sold is inflated by the amount of the merchandise that has been lost. The perpetual inventory system makes it easier to identify such losses. Because the Merchandise Inventory account is continuously updated for sales, purchases, and returns, the loss will show up as the difference between the inventory records and the physical inventory taken at the end of the accounting period. Once the amount of the loss has been identified, the ending inventory is updated by crediting the Merchandise Inventory account. The offsetting debit is usually an increase in Cost of Goods Sold because the loss is considered a cost that reduces the company’s gross margin.
Terms of sale
Manufacturers and wholesalers quote prices as a percentage off their list or catalogue prices. Such a reduction is called a trade discount. The list or catalogue price and related trade discount are used only to arrive at the agreed-upon price; they do not appear in the accounting records. On the invoice, the terms of sale are printed. The invoice can be marked “n/10” (“net 10”) which means that the amount of the invoice is due 10 days after the invoice date.
A sales discount is a discount for early payment. It can be labelled “2/10, n/30” which means that the buyer either can pay the invoice within 10 days of the invoice date and take a 2 percent discount or can wait 30 days and pay the full amount.
Special terms designate whether the seller or the purchaser pays the freight charges. FOB shipping profit means that the seller places the merchandise “free on board” at the point of origin and the buyer bears the shipping costs. The title to the merchandise passes to the buyer at that point. FOB destination means that the seller bears the transportation cost to the place where the merchandise is delivered. The seller retains title until the merchandise reaches its destination.
Applying the perpetual inventory system
Freight in, also called transportation in, is the transportation cost of receiving merchandise. The costs are accumulated in a Freight in account. Theoretically, freight in should be allocated between ending inventory and cost of goods sold, but most companies choose to include the cost of freight in with the cost of goods sold on the income statement because it is a relatively small amount.
Freight out expense, or delivery expense, absorb delivery costs.
When an item is returned from the merchandiser to the company it bought the merchandise from, the returned merchandise is removed from the Merchandise inventory account. P296.
Under the perpetual inventory system, at the time of a sale, the cost of the merchandise is transferred from the Merchandise Inventory account to the Cost of Goods Sold account. In the case of a return of sold merchandise, this works the other way.
Returns and allowances to customers for unsatisfactory merchandise are often an indicator of customer dissatisfaction. Such amounts are accumulated in a Sales Returns and Allowances (stockholders equity).
Record the following transactions:
Purchases of merchandise:
Oct 3 Merchandise received on credit, invoice dated Oct 1, terms n/10, $9780
Oct 6 Returned part of merchandise received on Oct 3 for credit, $960
Oct 10 Paid amount in full due for purchase of Oct 3, part of which was returned on Oct 6, $8820
Sales of merchandise:
Oct 7 Merchandise sold on credit, n/30, FOB destination $2400; cost of merchandise $1440
Oct 9 Accepted return of part of merchandise sold on Oct 7 for full credit and returned it to merchandise inventory, $600; the cost of the merchandise was $360.
Nov 5 Collected in full for sale of merchandise on Oct 7, less the return on Oct 9, $1800.
Applying the periodic inventory system
In this system, the cost of goods sold must be computed because it is not updated during the accounting period. To calculate this, goods available for sale must be determined.
Goods available for sale = beginning inventory + net cost of purchases during the year.
Cost of goods sold = goods available for sale – end inventory.
An important part of cost of goods sold is the net cost of purchases. This consists of net purchases plus freight charges on the purchases. Net purchases equal total purchases less any deductions, such as returns and discounts for early payment.
Because in the periodic inventory system the Merchandise inventory account is not adjusted after each inventory transaction, a Purchases or Sales account is used to accumulate the purchases or sales of merchandise during the accounting period. A Purchases or Sales Returns and Allowances account is used to accumulate returns on purchases or sales.
Record the following transactions:
Purchases of Merchandise:
Oct 3 Received merchandise purchased on credit, invoice date Oct 1, terms n/10, $9780
Oct 6 Returned part of merchandise received on Oct 3 for credit, $960
Oct 10 Paid amount in full due for the purchase of Oct 3, part of which was returned on Oct6, $8820.
Sales of merchandise:
Oct 7 Sold merchandise on credit, terms n/30, FOB destination, $2400 cost of merchandise was $1440.
Oct 9 Accepted return of part of merchandise sold on Oct 7 for full credit and returned it to merchandise inventory, $600, the cost of the merchandise was $360.
Nov 5 Collected in full for sale on Oct 7, less the return on Oct 9, $1800
An effective system of internal control has five interrelated components:
Control environment – this involves the company’s ethics, operating style, structure, personnel policy, etc.
Risk assessment – this involves identifying areas in which risks are high.
Information and communication - This pertains to the accounting system established by the management.
Control activities – the policies and procedures management puts in place to see that its directives are carried out.
Monitoring – this includes the management’s regular assessment of the quality of internal control.
Control activities involve: having managers authorize certain transactions, recording all transactions to establish accountability for assets, using well-designed documents to ensure proper recording of transactions, instituting physical controls, periodically checking records and assets, separation of duties, and using sound personnel practices.
The effectiveness of internal control is limited by the people involved. Human error, collusion, and failure to recognize changed conditions can contribute to a systems failure.
Internal control over merchandising transactions
For an effective internal control, most firms should use the following procedures:
Separate the functions of authorization, recordkeeping, custodianship of cash.
Limit the number of people who have access to cash, and designate who those people are
Bond all employees who have access to cash.
Keep the amount of cash on hand to a minimum by using banking facilities as much as possible.
Physically protect cash on hand by using cash registers, cashiers’ cages, and safes.
Record and deposit all cash receipts promptly, and make payments by check rather than by currency.
Have a person who does not handle or record cash make unannounced audits of the cash on hand.
Have a person who does not authorize, handle, or record cash transactions reconcile the Cash account every month.
Merchandise inventory consist of all goods owned and held for sale. There are three kinds of inventory:
Partially completed products
The costs of the goods includes raw materials, the cost of labour and the overhead costs. (indirect materials and labour, rent, depreciation and insurance).
The primary objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues. In accounting for inventories, management must choose among different processing systems, costing methods, and valuation methods. These different systems usually result in different amounts of reported net income.
Inventory turnover is a measure similar to receivable turnover. It measures the number of times a company’s average inventory is sold during an accounting period.
Inventory turnover = Cost of goods sold / average inventory
The days’ inventory on hand calculates the average number of days required to sell the inventory on hand.
days’ inventory on hand = number of days in a year / inventory turnover
There are several options to reduce the level of inventory. With supply-chain management a company manages its inventory and purchasing through business-to-business transactions that it conducts over the internet. In a just-in-time operating environment, the company makes sure that shipments arrive just at the time they are needed.
The gross margin is the difference between net sales and cost of goods sold. The higher the cost of ending inventory, the lower the cost of goods sold and the higher the resulting gross margin. Because the amount of gross margin has a direct effect on the amount of net income, the amount assigned to ending inventory directly affects the net income. Therefore it is important to correctly determine the ending inventory.
The effects of misstatements in inventory on income before income taxes are as follows:
Ending inventory overstated
Beginning inventory overstated
Cost of goods sold understated
Cost of goods sold overstated
Income before income taxes overstated
Income before income taxes understated
Ending inventory understated
Beginning inventory understated
Cost of goods sold overstated
Cost of goods sold understated
Income before income taxes understated
Income before income taxes overstated
The inventory cost includes the invoice price less purchases discounts, fright in and applicable taxes and tariffs. Goods flow refers to the actual physical flow of merchandise, whereas cost flow refers to the assumed flow of costs. Merchandise in transit can be included in the seller’s merchandise inventory when the goods are shipped FOB destination. When the goods are sold FOB shipping point, they are included in the buyer’s inventory. A consignment is merchandise that its owner (the consignor) places on the premises of another company (the consignee) with the understanding that payment is only expected when the merchandise is sold. Unsold items may be returned to the consignor. The lower-of-cost-or-market (LCM) rule states that if the replacement cost is lower than the original cost, the lower figure should be used.
Inventory cost under the Periodic Inventory System
There are four different ways to price inventory. They can be explained with the following data:
Specific identification method:
This method prices the inventory by identifying the cost of each item in ending inventory. If the inventory of June 30 consists of 50 units from the June 1 inventory, 100 units from the June 6 purchase, and 70 units from the June 25 purchase, then the cost of goods sold with the specific identification method are:
The method has two disadvantages: it is difficult to keep track of items and when items are identical, it is hard to say at which price they were bought.
Under this method, the inventory is priced at the average cost of the goods available for sale during the period.
Cost of goods available for sale / Units available for sale = average unit cost
€6350 / 500 units = $12.70
First-in, First-out method (FIFO)
This method assumes that the costs of the first items acquired should be assigned to the first items sold. The costs of the goods on hand at he end of a period are assumed to be from the most recent purchase.
This method gives the highest net income, because cost of goods sold will show the earliest cost incurred, which are usually lower.
Last-in, First-out method (LIFO)
This method assumes that the costs of the last items acquired should be assigned to the first items sold. The cost of ending inventory reflects the cost of the oldest purchases.
This method does not reflect the actual physical movement of goods in businesses. The argument that supports LIFO is that when goods are sold in a business, they are replaced with new goods. These new goods have usually higher purchase prices. The LIFO method shows the cost of goods sold at the price level when goods were sold.
Impact on Inventory Decisions
During a period of increasing prices, the LIFO method produces a lower gross margin than the FIFO method. The opposite occurs when there is a period of declining prices.
Each of the four methods is acceptable for use in published financial statements. A basic problem in determining the best inventory measure for a particular company is that inventory affects both the balance sheet and the income statement. LIFO is best suited for the income statement because it matches revenues and cost of goods sold. FIFO is best suited to the balance sheet because the ending inventory is closest to current values.
Over a period of rising prices, a company that uses LIFO may find that its inventory is valued at a cost far below what it currently pays for the same items. When inventory at the end of the year is less than at the beginning of the year, the company has to pay higher income taxes. This is called LIFO liquidation.
Inventory cost under the Perpetual Inventory System
Under the perpetual system, cost of goods sold is accumulated as sales are made and cost are transferred from the Inventory account to the Cost of Goods Sold account. Assume that this is the movement of inventory in a company:
Under the perpetual system, the average is computed after each purchase:
Under the FIFO method, instead of calculating an average after each purchase, the price of the first purchase price is used when a sale occurs.
Under the LIFO method, the last purchase price is used when a sale occurs. See p.352 for an example.
Valuing inventory by estimation
Sometimes the value of ending inventory has to be estimated. Two methods are commonly used:
Retail method: is used in retail merchandising. It uses the ratio of cost to retail price. At retail means the amount of the inventory at the marked selling prices of the inventory items. The value of goods available for sale at cost is divided by the value of goods available for sale at retail. (this gives the ratio of cost to retail price) The ending inventory at retail is determined by subtracting the net sales during the period from the goods available for sale at retail. This amount is multiplied by the ratio. This gives the estimated cost of ending inventory.
Gross profit method: assumes that the ratio of gross margin remains stable from year to year. The cost of goods available for sale should be established in the usual way. The cost of goods sold should be calculated by deducting the estimated gross margin of 30 percent from sales. Then, deduct the estimated cost of goods sold from the goods available for sale to get the estimated cost of ending inventory.
Management issues related to cash and receivables
The management of cash and receivables is critical to maintaining adequate liquidity. In dealing with cash and receivables, management must address five key issues:
Managing cash needs
Management must consider the need for short-term investing and borrowing during seasonal cycles.
Setting credit policies that balance the need for sales with the ability to collect
Evaluating the level of accounts receivable
Two methods that are often used to measure the effect of a companies credit policies are receivable turnover and average days’ sales uncollected. The first is the relative size of accounts receivable and the success of its credit and collection policies. It should be calculated in the following way:
Receivable turnover = net sales / average net accounts receivable
The second is how long it takes to collect accounts receivable:
Average days’ sales uncollected = days in a year / receivable turnover
Companies can raise funds by selling or transferring accounts receivable to another entity, called a factor. The sale can be done with recourse which means that the seller of the receivables is liable to the purchaser if a receivable is not collected. Without recourse means the seller is not liable. A potential liability that can develop into a real liability is called a contingent liability. In this case it would be non-payment of the receivable by the customer.
Another thing a company can do is securitization. This means the company groups its receivables in batches and sells them at a discount to companies and investors.
A third method is called discounting. This is the selling of promissory notes held as notes receivable. The back deducts the interest from the maturity value of the note to determine the proceeds. The seller has a contingent liability in the amount of the discounted notes plus interest.
Understanding the importance of ethics in estimating credit losses.
Cash equivalents and cash control
Cash can include cash equivalents. These are investments of less than 90 days. Coins on hand can be controlled through an imprest system. A common form is a petty cash fund. It is set at a fixed amount and all receipts of cash payments must be collected. The fund is periodically reimbursed by the exact amount necessary to restore its original cash balance. Many companies conduct transactions through electronic transportation called electronic funds transfer (EFT).
A bank reconciliation is the process of accounting for the difference between the balance on the company’s bank statement and the balance on its Cash account. It involves adjusting for outstanding checks, deposits in transit, service charges, NSF (non sufficient funds) checks, miscellaneous debts and credits, and interest income.
Accounts receivable arise from sales on credit. Accounts owed by customers who cannot or will not pay their debts are called uncollectible accounts. The direct charge-off method is often used by small companies. They reduce Accounts Receivable directly and increase Uncollectible Accounts Expense.
Companies that follow GAAP prefer the allowance method. Here, bad debt losses are matched against the sales they help to produce. Because at the time sales are made, it can not be identified which customers will not pay their debits, losses must be estimated. A new account called ‘Allowance for Uncollectible Accounts’ will appear on the balance as a contra account from accounts receivable. Example: From the $100,000 in accounts receivable, $6,000 is estimated to be uncollectible at the end of the year:
Uncollectible accounts expense
Allowance for uncollectible accounts
Short time investments
Less allowance for uncollectible accounts
Total current assets
There are two common methods for estimating uncollectible accounts expense:
Percentage of Net Sales Method: Management establishes a percentage of net sales that they think will not be collected. This can be an average of the past few years. This amount will be recorded as follows:
Uncollectible Accounts Expense
Allowance for Uncollectible Accounts
The allowance for uncollectible accounts will be added to the amount from previous years.
Accounts receivable aging method: The year-end balance of Allowance for Uncollectible Accounts is determined directly by an analysis of accounts receivable. The difference between the amount determined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the year. The aging of accounts receivable is the process of listing each customer’s receivable account according to the due date of the account.
Each due date has its own percentage that will not be collected.
When the Allowance for Uncollectible Accounts has a credit balance, the difference between the amount calculated and the credit balance should be added to the account.
When the Allowance for Uncollectible Accounts has a debit balance, the calculated amount and the debit amount should be added together before adding the total to the account.
When it becomes clear that a specific account receivable will not be collected, the amount should be written off to Allowance for Uncollectible Accounts. For example, when a company goes bankrupt, and its still owes you $300, it will be recorded in the following way:
Allowance for Uncollectible Accounts
Suppose that all of a sudden the company does find a way to pay you, the following journal entries must be made:
Allowance for Uncollectible Accounts
A promissory note is an unconditional promise to pay a definite sum of money on demand or a future date. The entity who signs the note and promises to pay is called the maker of the note. The entity to whom the payment is to be made is called the payee.
They maturity date is the date on which a promissory note must be paid. The duration of note is the length of time in days between a promissory note’s issue date and its maturity date, Interest is the cost of borrowing money or the return for lending money. The maturity value is the total proceeds of a promissory note –face value plus interest-at the maturity date. When the maker of a note does not pay the note at maturity, it is said to be an dishonoured note.
Long term assets are assets that:
Have a useful life of more than one year
Are acquired for use in the operation of a business (assets not used in the normal course of business, such as land held for speculative reasons, should not be included)
Are not intended for resale to customers
Long-term assets are reported at carrying value, this is the unexpired part of the cost of an asset, also called book value. It is not the market value of an item. Asset impairment occurs when the sum of the expected cash flows from the asset is less than the carrying value of the asset. A reduction in carrying value as a result of impairment is recorded as a loss.
(such as plant, buildings)
Less accumulated depreciation
(such as mines, oil)
Less accumulated depletion
(such as copyrights, goodwill)
Less accumulated amortization
The decision to acquire a long-term asset includes a complex process. First the purchasing costs of the asset have to be determined. Then, the savings which the asset generates in its life time have to be written in present value. Third, the disposal price (if any) has to be written in present value. When adding all of them together, and the outcome is positive, the asset will be profitable. Example: A $50,000 software package, making the company save $20,000 for four years, with a disposal price of $10,000 and a 10% interest rate:
Present value factor = 1000
1000 x $50,000
Net annual savings in cash flows
Present value factor = 3.170
(Table 4 p812, 4 periods, 10%)
3,170 x 20,000
Present value factor = 0.683
(Table 3 p810, 4 periods, 10%)
0,683 x 1000
Net present value
There are a few issues when accounting for long-term assets. The first one is how much of the total cost has to be allocated to expense in the current accounting period. The second is how much to retain on the balance sheet as an asset to benefit future periods.
There are four questions that have to be answered before accounting for the long-term asset.
How is the cost of the long-term asset determined?
How should the expired portion of the cost of the long-term asset be allocated against revenues over time?
How should subsequent expenditures, such as repairs, be treated?
How should disposal of the asset be recorded?
The accounting problem is to spread the cost of the services of the asset over its useful life.
Acquisition cost of property, plant and equipment
Expenditure refers to a payment or an obligation to make future payment for an asset or a service. A capital expenditure is an expenditure for the purchase or expansion. They are recorded in the asset accounts. Revenue expenditure is related to the repair and maintenance of a long-term asset. They are recorded in an expense account because their benefits are realized in the current period.
Capital expenditures include outlays for plant assets, natural resources, and tangible assets. They also include expenditures for additions, betterments and extraordinary repairs.
An addition is an enlargement to the physical layout of a plant asset. A betterment is an improvement that does not ad to the physical layout of a plant asset. They should both be debited to the asset account. Ordinary repairs are necessary to maintain an asset in good operating condition. These repairs are current expense. Extraordinary repairs are repairs that affect the estimated residual value. They are recorded by debiting the Accumulated Depreciation account, assuming that some of the depreciation previously recorded has now been eliminated.
Cost of the asset is equal to the cash paid for the asset plus expenditures such as freight. If a debt is incurred in the purchase of the asset, the interest charges are not a cost of the asset, but a cost of borrowing money to buy the asset. This makes is an operating expense. Many companies establish policies explaining when an expenditure is an expense or an asset.
Land: Expenditures that should be debited to the Land account are commissions to real estate agents, accrued taxes paid by the purchaser and assessments for local improvements. Land is not subject to depreciation.
Land Improvements: Some improvements to real estate that are subject to depreciation should be recorded in an account called Land Improvement.
Buildings: The new contract price plus other expenditures necessary to put the building in usable condition are included in the cost.
Equipment: The cost include all expenditures that have to do with purchasing the equipment and preparing it for use.
Group purchases: When land and other assets are purchased for a lump sum, they must have a separate ledger account because land is depreciable asset. The lump-sum purchase price must be apportioned between land and other assets.
All tangible assets except land have a limited useful life. The physical deterioration of tangible assets results from use and from exposure to the elements. Obsolescence is the process of becoming out of date. Depreciation does not refer to an asset’s physical deterioration or decrease in market value over time. It is not a process of valuation.
Four factors affect the computation of depreciation:
Cost. This is the net purchase price plus all necessary expenditures
Residual value: This is the trade-in value as of the estimated date of disposal
Depreciation cost: The cost less its residual value
Estimated useful life: The total number of service units expected from the asset.
Methods of computing depreciation:
(Cost - Residual Value) / Estimated Useful Life
The depreciation is the same each year, the accumulated depreciation increases uniformly and the carrying value decreases uniformly until it reaches the estimated residual value.
Production method: This method assumes that depreciation is the result of use and that time plays no role in the depreciation process.
(Cost - Residual Value) / Estimated Units of Useful Life
This method should only be used when the output of an asset over its useful life an be estimated with reasonable accuracy.
Declining-balance method: An accelerated method of depreciation results in relatively large amounts of depreciation in the early years of an asset’s life and smaller amounts in later years. It assumes that assets are most efficient when new. It also recognizes that because of fast-changing technology, equipment can become obsolescent. With the declining-balance method depreciation is computed by applying a fixed rate to the carrying value of an asset. The most common rate is a percentage that is equal to twice the straight-line depreciation percentage. This is called the double-declining-balance method.
Group depreciation: When some pieces last longer than others pieces of the same kind, companies can groups similar items and take the average to calculate depreciation.
Revision of depreciation rates: Assume an asset is worth $7000 with a residual value of $1000 and an estimated useful life of six years. After two years of straight line depreciation, $2000 is the accumulated depreciation and $4000 is the remaining depreciable cost.
Assume that after these two years, the company finds out the truck only has a useful life left of two years, instead of the assumed remaining four. The next two years, the depreciation should be $4000 – 2 years = $2000 each year.
Disposal of depreciable assets
Discarded plant assets: When machinery is discarded, the proper amount of depreciation should be computed until the month in which the item is discarded. This amount should be accounted for under ‘Accumulated Depreciation, Machinery’. The carrying value is the machinery cost less accumulated depreciation. This should be recorded as ‘Loss on Disposal of Machinery’. Assume machinery has accumulated depreciation of $4650, and the amount in the Machinery account is $6500:
Accumulated depreciation, machinery
Loss on disposal of machinery
Plant assets sold for cash: Assume the cash received is $1850:
Accumulated depreciation, machinery
Sale of machine for carrying value
no gain or loss
Assume the cash received is $1000
Accumulated depreciation, machinery
Loss on sale of machinery
The opposite occurs when more than the carrying value is received in cash.
Exchanges of plant assets: For both financial accounting and income tax purposes both gains and losses are recognized when a company exchanges dissimilar assets. When items are similar, only losses are recognized for financial accounting purposes.
Accounting for natural resources
Natural resources are recorded at acquisition cost. When the resource is converted into inventory, the asset account must be reduced when inventory increases. This way, the original cost is gradually reduced, and depletion is recognized in the amount of the decrease. The depletion cost per unit is determined by dividing the cost of the natural resource less residual value) by the estimated number of units available. When machinery with a useful life of twelve years is build on a coal mine that is expected to be depleted in ten years, the machinery should be depreciated over the ten-year period, using the production method.
Under successful efforts accounting only the cost of a successful exploration are recorded as cost of the resources. Failures such as dry wells are written off as being a loss. With the full-costing method, all costs, including failures, are recorded as assets and depleted.
Accounting for intangible items
The purchase of an intangible asset should be treated as a capital expenditure and recorded at acquisition cost, and should be amortized over the useful life of the asset.
All costs that have to do with Research and Development should be treated as revenue expenditures and charged to expense in the period in which they are incurred.
Costs that have to do with developing computer software for sale are research and development costs until the product has proved technologically feasible.
Goodwill is the amount that people are willing to pay for a company more than the value of the net assets if purchased individually. It should be reported separately on the balance sheet.